Forward 91880i v2 Financial Development and Inclusive Growth Attaining Shared and Sustainable Prosperity in Egypt ii Financial Development and Inclusive Growth Forward iii Middle East and North Africa Finance and Private Sector Development Financial Development and Inclusive Growth Attaining Shared and Sustainable Prosperity in Egypt A Study Led By Sahar Nasr iv Financial Development and Inclusive Growth Forward v This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The Contents World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The Abbreviations and Acronyms ix World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Forward xi Acknowledgments xv Executive Summary xix Overview of The Financial Sector 1 Financial Development and Inclusive Growth 2 Main Components of the Financial Sector Reform Program 8 Achievements and Main Outcomes 14 Post-revolution Risks and Challenges 21 Concluding Remarks 30 Banks, Economic Growth and Opportunity 33 Finance: Pro-Growth and Pro-Poor 33 Financial System–Growing from a Low Level 39 Financing Egypt Post-Revolution–New Opportunities and New Challenges 52 Concluding Remarks 63 The Development of the Capital Markets 67 Equity Markets 67 Fixed Income Markets 84 Concluding Remarks 111 Non-Bank Financial Institutions 115 Insurance and Pensions 115 Mortgage Market 132 Financial Leasing and Factoring 147 Concluding Remarks 154 Financial Sector Integrity and Economic Growth 159 Banking Supervision 160 Non-Bank Financial Services Regulation 188 Legal and Institutional Framework 201 Concluding Remarks 207 Financial Sector Development Agenda 211 References 237 vi Financial Development and Inclusive Growth Forward vii Figures Tables Figure 1.1 Number of Primary Lenders Extending Mortgage Loans 11 Table 1.1 Egypt—Banking Soundness Indicators 17 Figure 1.2 Capital Adequacy of the Banking System 14 Table 1.2 MTPL Claims Ratios by Accounting Year 20 Figure 1.3 NPLs-to-Total Loans 15 Table 1.3 Islamic Banks Share in Total Banking Sector 29 Figure 1.4 Credit by Banks to the Government versus Credit to Private Sector 21 Table 2.1 Reasons for Not Applying for a Loan or Line of Credit 51 Figure 1.5 Islamic Finance Penetration in Selected Countries 27 Table 3.1 Stock Market Capitalization as a Percentage of GDP 69 Figure 2.1 Finance and Growth across Countries (1980–2007) 34 Table 3.2 Number of Listed Companies 69 Figure 2.2 Finance and Poverty Alleviation across Countries (1980–2007) 36 Table 3.3 Number of Initial Public Offerings 70 Figure 2.3 Actual and Predicted Level of Bank Deposits-to-GDP 42 Table 3.4 Stock Market Turnover Ratios 71 Figure 2.4 Actual and Predicted Level of Private Credit-to-GDP 42 Table 3.5 Mutual Fund Assets 73 Figure 2.5 Sectoral Lending Share of Egypt’s Banking Sector (2009) 44 Table 3.6 Monetary Policy Instruments in Egypt 86 Figure 2.6 Maturity Structure of Egyptian Banks (2007–2009) 45 Table 3.7 Overview of Corporate Bonds in Egypt as of December 2010 94 Figure 2.7 Percentage of Firms that have Access to Bank’s Credit 47 Table 3.8 Structure on Securitized Issues as of December 2010 95 Figure 2.8 Firms identifying Access to Finance as a “Major” or “Very Severe” Table 3.9 Structure of Banks’ Securities Portfolios Expressed as a Percentage 103 Obstacle 48 Table 3.10 Distribution of T-Bond Holders as of March 31, 2008 103 Figure 2.9 Financial Depth versus Enterprise Use of Bank Credit 48 Table 3.11 Evolution of Mutual Funds 104 Figure 2.10 Types in Egypt-Share of Firms with Bank Credit 49 Table 3.12 Holdings of Money Market Mutual Funds 104 Figure 2.11 Percentage of Firms Having Access to Banks Credit in Egypt 50 Table 3.13 Assets under Management 106 Figure 2.12 Reasons for not having a Loan in Egypt across Different Firm Types 50 Table 4.1 Performance Ratio of the Insurance Sector (2004–2013) 118 Figure 3.1 Evolution of the Structure of Domestic Debt 88 Table 4.2 Private Pension Funds (2004–2013) 120 Figure 3.2 Egypt’s Market Capitalization in GEMX 90 Table 4.3 Misr Insurance Performance Ratios 121 Figure 3.3 T-Bond Issuances in 2011 91 Table 4.4 Misr Life Performance Ratios 121 Figure 3.4 T-Bond Annual Maturity Profile 91 Table 4.5 State-owned Insurer General and Administrative Expense Ratios 121 Figure 3.5 Government Bonds Trading Volume 100 Table 4.6 Adjusted Premium per Insurance Employee 122 Figure 3.6 Evolution of Foreign Investor Holdings of Domestic Debt in Table 4.7 Private Pension Funding Levels 125 Percentage 107 Table 4.8 MTPL Claims Ratios (2007-2013) 126 Figure 3.7 Central Depositary: Existing model for T-Bills and T-Bonds 108 Table 4.9 State-owned insurer Claims Ratios by Underwriting 126 Figure 3.8 Proposed Model 1: T-Bills and T-Bonds under CBE 109 Table 4.10 Household Savings Through Financial Institutions in Egypt 128 Figure 3.9 Proposed Model 2: Connectivity between CBE and MCDR 110 Figure 4.1 Private Sector Re-entry to the MTPL Market 119 Boxes Figure 4.2 MTPL Premium Penetration Versus Vehicle Density 123 Box 1.1 The Role of State-owned Banks and Government Intervention in Figure 4.3 Fiscal Balance–Old and New Public Pension Systems 130 7 Credit Allocation Figure 4.4 Mortgage Debt Outstanding 133 16 Box 1.2 The Principal Bank for Development & Agricultural Credit Figure 4.5 Mortgage Debt Outstanding to GDP 133 25 Box 1.3 Lack of Legal and Regulatory Framework for Microfinance Figure 4.6 Mortgage Debt-to-GDP 133 26 Box 1.4 Evolution of Islamic Finance in Egypt Figure 4.7 Egypt and Peers Urbanization Rates 1950–2050 139 38 Box 2.1 Three Concepts of Finance Figure 4.8 Egypt Housing Demand (Household Formation Rate) 140 53 Box 2.2 Reform Experience from Transition Economies Figure 4.9 Housing Supply in Greater Cairo 141 151 Box 4.1 The Egyptian Leasing Association Figure 4.10 Growth of the Leasing Industry 148 173 Box 5.1 Example of SME Rating Agency: India’s SMERA Figure 4.11 Leasing Company Market Share for Q4 of 2011- Growth of the 186 Box 5.2 Special Provisions for SME Funding Leasing Industry 149 Figure 4.12 Value of Leasing Contracts 150 Figure 5.1 Legal Rights of Creditors in Egypt and Other Countries 203 Figure 5.2 Cost to Create Collateral in Egypt and Other Countries 204 Figure 5.3 Dominance of Collateral-Based Lending in Egypt 206 viii Financial Development and Inclusive Growth Forward ix Abbreviations and Acronyms ACH Automated Clearing House IPO Initial Public Offering AFDB African Development Bank LA/TA Liquid Assets to Total Assets Ratio AOB Accounting Oversight Board LE Egyptian Pound AUM Assets under Management MCDR Misr for Central Clearing Depository & Registry AWB Al Watany Bank of Egypt MENA Middle East and North Africa BCCI Bank of Credit and Commerce International MFA Mortgage Finance Authority CAR Capital Adequacy Ratio MFC Mortgage Finance Company CB Conventional Banks MFI Micro Finance Institutions CBE Central Bank of Egypt MMMF Money Market Mutual Fund CCP Central Counterparty MOU Memorandum of Understanding CD Certificate of Deposit MTPL Motor Third Party Liability CIB Commercial International Bank NAV Net Asset Value CIS Collective Investment Schemes NBE National Bank of Egypt CIS Commonwealth of Independent States NBD National Bank for Development CMA Capital Market Authority NBFI Non-bank financial institutions CSD Central Securities Depository NHP National Housing Program DB Defined Benefit NIB National Investment Bank DD Domestic Debt NPL Non-Performing Loans DIFF Differential NSB Nasser Social Bank DVP Delivery versus payment NUCA New Urban Communities Authority EALB Egyptian Arab Land Bank OOP Out of pocket (health expenses) EAS Egyptian Accounting Standards OTC Over the Counter ECB European Central Bank PAYGO Pay as you go (i.e. no pre-funding) EDR Egyptian Depository Receipt PBDAC Principal Bank for Development & Agricultural Credit EFSA Egyptian Financial Supervisory Authority PD Primary Dealer EISA Egyptian Insurance Supervisory Authority PE Private Equity EMEs Emerging Market Economies PPP Public-Private Partnership EMRC Egypt Mortgage Refinance Company PTES Program for Treatment at the Expense of the State EGX Egyptian Stock Exchange REPO Repurchase Operation/Agreement ERSAP Economic Reform & Structural Adjustment Program REFA Real Estate Finance Authority ESA Egyptian Survey Authority ROAA Return on Average Assets Ratio ETA Equity to Total Assets Ratio RTGS Real Time Gross Settlement ETF Exchange Traded Funds SBL Stock-Borrowing and Lending Facility FPM Financial Projection Model SDP Supervisory Development Plan GCC Gulf Co-operation Council SFD Social Fund for Development GAFI General Authority for Free Zones & Investment SGF Settlement Guarantee Fund GDRs Global Depository Receipts SIF Social Insurance Fund HIO Health Insurance Organization SME Small and Medium Enterprises HNW High Net Worth SOE State-owned Enterprises IAS International Auditing Standards SRO Self-Regulatory Organization IDB Industrial Development Bank of Egypt SDP Supervisory Development Plan IFIs International Financial Institutions TA Technical Assistance IFRS International Financial Reporting Standards VC Venture Capital IHC Insurance Holding Company USAID US Agency for International Development INFTAX Inflation Tax x Financial Development and Inclusive Growth Forward xi Forward Better functioning financial systems foster economic growth, poverty alleviation; moreover, a more equitable distribution of economic opportunities enhances overall economic development. It is critical that financial development leads to inclusive growth. This brings us to certain key questions: Who benefits from a better financial system? Does financial development induce an increase in per capita Gross Domestic Product (GDP) only because the very rich are getting even richer? Does finance expand economic opportunities for the bulk of society? Economic theory suggests that finance shapes the distribution of economic opportunities. The financial system affects the degree to which a person’s economic opportunities are defined. It influences who can launch a new business venture and who cannot, who can acquire education and who cannot, who can live in a neighborhood that fosters the cognitive and non-cognitive development of their children and who cannot, who can pursue one’s economic dreams and who cannot. A more competitive, better functioning financial system exerts a disproportionately positive impact on relatively low-income families. A large body of evidence finds that the functioning of the financial system influences the rate of long-run economic development, poverty alleviation, and the degree to which families and firms with sound investment projects have access to capital. When financial systems xii Financial Development and Inclusive Growth Forward xiii effectively seek out the best investments, efficiently mobilize resources forward policy implications, given international best practice while to fund those investments, and carefully scrutinize the use of those taking into account lessons learnt from previous reforms in Egypt funds by firms and individuals, this tends to accelerate economic and what is needed to respond to the Egyptian people aspiration post development, alleviate poverty, and reduce income inequality. The revolution. greater the degree that financial systems collect society’s savings with one hand and funnel those resources, this tends to foster growth, promote poverty alleviation, increase inclusivity in the available economic opportunities and expands economic opportunities. Thus, the financial system affects the savings rate and the efficiency of Hartwig Schafer resource allocation, with enduring ramifications on economic activity. Country Director Therefore, getting the financial system to operate soundly is vital to Egypt, Yemen and Djibouti fostering sustained economic development. The World Bank Group According to the extent that the financial system performs these functions well, economies tend to grow correspondingly faster. For example, when banks screen borrowers effectively and identify firms with the most promising prospects, this is a first step in boosting productivity growth. When financial markets and institutions mobilize savings from disparate households to invest in these promising projects, this represents a second crucial step in fostering economic growth. When financial institutions monitor the use of investments after financing firms and scrutinize their managerial performance, this is an additional, essential ingredient in boosting the operational efficiency of corporations, reducing waste and fraud, and spurring economic inclusivity. There is a robust positive relationship between financial development and both poverty alleviation and reduction in income inequality. It is not just that finance accelerates economic growth, which trickles down to the poor; rather, finance exerts a disproportionately positive influence on lower income households. Building on the finance and poverty connection, there is a direct link between finance and human welfare. When policy reforms foster the development of the financial system, financial services improve, accelerating economic growth, which ultimately leads to ending extreme poverty and boosting shared prosperity. So where is Egypt when benchmarked with other emerging and developing economies? During the post-revolution transition, Egypt has been debating fundamental issues, such as maintaining market-oriented reforms, and promoting private sector-led growth. As uncertainty continues, reforms are debated, and crisis management is in full swing. A pressing challenge towards moving forward is the proceeding with the appropriate policy reforms, and this report puts xiv Financial Development and Inclusive Growth Acknowledgments xv Acknowledgments The Egypt Financial Development and Inclusive Growth report was prepared by a team led by Sahar Nasr, Program Leader; and comprised of Asli Demirgüç-Kunt, Director, Development Economics and Chief Economist (Financial Development); Santiago Herrera, Lead Economist; Ahmed Kouchouk, Senior Economist; Karim Badr, Financial Economist (Macroeconomic Stability); Erik Feyen, Lead Financial Sector Economist (Financial Development); Ross Levine, Wilis H. Booth Chair in Banking and Finance, Haas School of Business (Financial Development); Catiana Garcia- Kilroy, Lead Securities Market Specialist (Non-Bank Financial Institutions); Anderson Caputo Silva, Lead Securities Market Specialist; Simon Walley, Housing Finance Program Coordinator (Egypt’s Mortgage Market); James Hanson, Visiting Professor of Economics, Center for Development Economics, Williams College, Williamstown Mass (Banks Economic Growth); Thorsten Beck, Professor of Economics, Tilburg University, and Founding Chair of European Banking Center (Banks Economic Growth); Jonathan Katz, former Secretary of the U. S. Securities and Exchange Commission (Capital Market Regulation and Economic Growth); Nabil Hashad, Former Chair, Arab Center for Financial and Banking Studies and Consulting (Islamic Finance); Monal Abdel Baki, Research Professor, Durban University of Technology; Rodney Lester, Insurance Sector Expert (Insurance and Pensions); Bahaa Ali El Dean, Attorney-at-Law, Arab Legal Consultants (Financial Sector Integrity); Henri Lorie, Financial Economist (Legal Framework); Hoda Youssef, Research Fellow, Woodrow Wilson School of International and Public Affairs of Princeton University (Macroeconomic Stability); Laila xvi Financial Development and Inclusive Growth Acknowledgments xvii Abdelkader, Financial Sector Specialist (Overview of the Financial Sector); Leasing Association. The authors are grateful to the guidance provided by Nahla El Okdah, Associate Operations Officer, IFC (Financial Leasing); the various stakeholders and private banks, especially Mr. Omar El Sayeh, and Mohamed Farid, Chairman and CEO, Dcode Economic and Financial Chairman Barclays Bank; Mr. Abdelsalam El Anwar, Chairman, HSBC; Consulting (Capital Market). Mr. Hisham Ezz Al Arab, Chairman and Managing Director, Commercial International Bank (CIB); Dr. Yasser Hassan, Managing Director, Al Watany Special gratitude is also due to Hartwig Schafer, Director, Egypt, Bank of Egypt (AWB); and Mr. Sherif Battisha, Deputy Chairman Post Office. Yemen and Djibouti; and Loic Chiquier, Director, Financial and Private The team would also like to thank Mr. El Sayed El Kosayer, Chief Executive Sector Development, and Capital Markets Global Practice, for their guidance. Officer, Industrial Development and Workers Bank; Mr. Hassan Abdallah, Thanks are also due to Mr. Simon Bell, Sector Manager, Finance and Private Chief Executive Officer and Vice Chairman Arab African Bank; and Mr. Sector Development, Middle East and North Africa (MENA) Region. The Bruno Gamba, Chairman and Managing Director Bank of Alexandria. The authors are grateful to the peer reviewers Caroline Freund, Chief Economist; team would also like to acknowledge the countless other individuals from the Marilou Jane Uy, Senior Adviser; Sophie Sirtaine, Sector Manager; Michel banking, insurance and capital markets sectors who have contributed to the Noel, Service Line Manager; Yusuf Shahid, Chief Economist for the Growth preparation process. Dialogue, School of Business, George Washington University; and Didier Debals, Inspector General, Banque du France. The team would also like to thank Nada Shousha, Principal Country Officer, IFC; Xavier Reille, Manager, IFC; James Christopher Razook, Senior Operations Officer IFC; Amira El Saeed Agag, Operations Officer, IFC; Murat Sultanov, Operations Officer, IFC; and Ola Nour, Operations Officer, IFC. The report benefited significantly from the guidance and support of Patrick Conroy, Former Director and Senior Advisor. The authors would also like to acknowledge the contribution of Mauricio Pinzon Latorre, Research Assistant; Marwan Ezz Al Arab, Research Assistant; Lina Badawy, Research Assistant; Nehal Helmy, Research Assistant; Rana Hegazy, Research Assistant; Mostafa Abu El-Ela, Research Assitant; Amira Zaky, Program Assistant; and Nayyera Qutb, Team Assistant. The World Bank team greatly appreciates the close collaboration with the government of Egypt. Special gratitude and appreciation goes to H.E. Dr. Farouk El Okdah, Former Governor, Central Bank of Egypt (CBE). Thanks are also due to H.E. Mr. Hisham Ramez, Governor, Central Bank of Egypt (CBE); Mr. Gamal Negm, Deputy Governor CBE; Mr. Nidal Al-Kassem Assar, Deputy Governor CBE; Ms. May Aboul Naga, Regulations Department Head, CBE; Ms. Lobna Helal, Chairman and Managing Director, Egyptian Mortgage Refinance Company; and Dr. Sherif Samy, Chairman, Egyptian Financial Supervisory Authority (EFSA); Mr. Mohamed Omran, Chairman, Egyptian Exchange and Mr. Samy Khallaf, Debt Manager Ministry of Finance. Extensive consultation with stakeholders, private sector, banks, insurers, mortgage finance companies, and civil society took place throughout the preparation of the report. The team also wishes to thank Mr. Hisham Okasha, Deputy Chairman National Bank of Egypt; Mr. Mounir El Zahid, Chief Executive Officer, Banque Du Caire; Mr. Mohamed Naguib, Chairman and Managing Director, Societe Arabe Internationale De Banque; Mr. Mohamed Amiri, Head of Marketing and Credit Division, Societe Arabe Internationale De Banque; and Dr. Shahinaz Rashad, Chairman, Egyptian xviii Financial Development and Inclusive Growth Executive Summary xix Executive Summary Prior to the revolution, Egypt had been Prior to the hit by the global financial crisis along with revolution, Egypt higher international food and fuel prices, which had been hit by induced capital outflows, a moderate slowdown the global crisis, in economic activity, stagnation in employment namely food, fuel growth, and high inflation due to rising food and financial prices. As the country was recovering from such crisis, which external shock and capital inflows started to flow induced a capital back, the 2011 revolution sent the economy into a outflow, a moderate tailspin. The Egyptian economy continues to be growth slowdown, adversely affected by the ongoing political unrest stagnation in and violence. Economic activity started to pick employment growth, up in the second half of FY14, as the government and high inflation accelerated its stimulus spending, but growth due to rising food is still feeble at 2.2 percent in 2014 (well below prices. As the country potential), similar to growth rates realized in the was recovering previous two years . The sluggish growth reflects from that shock and mainly contraction in the petroleum and tourism capital had started sectors. On the demand side, real investment flowing back, the continued to shrink in real terms due to high January 25, 2011 uncertainty and net exports remain a drag on revolution sent growth. However, the remainder of 2014 may the economy into a witness an improvement in economic activities, tailspin. thanks to the accommodative government xx Financial Development and Inclusive Growth Executive Summary xxi policies pursued, including a notable stimulus Treasury bills that represent 41 percent of the backed partially by the Gulf aid packages. Gulf banking system assets, accounting for 40.0 States Saudi Arabia, United Arab Emirates percent of GDP, leaving little loanable funds and Kuwait, pledged around US$24 billion in available. Claims on the government to-total financial aid to Egypt since July 2013, of which domestic credit have increased to 60 percent, around US$17-18 (Cash and in kind) billion has while claims on the private sector credit dropped been received in 2014. to 37 percent in June 2013, as opposed to 54. The overall instability has adversely Starting 2014, with the exceptional affected investments and the private sector. financing from the Gulf trickling in, reserves Domestic investment fell to 13.1 percent of Gross increased to around US$17 billion at the end of Domestic Product (GDP) in 2014. Foreign direct September 2014 (equivalent to about 3 months of investments (FDI) have fallen to 1.1 percent of 2014 projected merchandise imports). In tandem, GDP in 2013. The sluggish growth and domestic the exchange rate appreciated during first half demand, high government borrowing needs, risk of 2014 before it started to slightly depreciate to averse practices by the banking sector, and the reach LE 7.15 per US dollar by end May 2014 drop in national investments and savings had and stabilized since then. However, a parallel a negative effect on the creation and growth market premium that had emerged by end- of micro and small enterprises (MSEs). These 2012 due to foreign exchange rationing—is still factors have contributed to an increase in persistent. The relative improvement in Egypt’s unemployment and poverty rates. Unemployment external conditions prompted rating agencies to increased from 8.9 percent in December 2010 to upgrade Egypt’s sovereign rating and outlook. 13.3 percent in June 2014. It is particularly high In November 2013, Standard and Poor’s raised among women at 25 percent and youth at 42 Egypt’s long- and short term foreign and local percent. The poverty rate also increased to 26.3 currency sovereign credit rating to ‘B /B’, with percent in 2013, up from 25 percent in 2011 and a ‘stable’ outlook. Fitch also upgraded Egypt’s 21.6 percent in 2009. outlook to ‘stable’ in January 2014. Egypt’s fiscal situation has been However, with the election of El-Sissi Egypt has been deteriorating sharply since 2010 due to weak as the president in June 2014, the economy is undergoing major real growth, adoption of populist measures, and expected to stabilize, and economic recovery is political and social the lack of corrective actions. The overall budget likely as the government moves forward with transformations, deficit reached 12.5 percent of GDP in 2014, down implementing the reform program, including following the from 13.7 percent a year earlier on the backdrop making the financial system more inclusive, January 2011 Starting 2014, with of exceptional Gulf receipts and the one-off a key contribution and reform to restoring revolution. Egypt the exceptional transfer of government deposit worth Egyptian economic growth and making it more inclusive. has embarked on a financing from the Pounds (LE) 30 billion from the Central Bank Egypt has been undergoing major political dramatic political Gulf trickling in, of Egypt (CBE) to the Treasury. However, fiscal and social transformations, following the transition with the reserves increased aggregates are likely to temporarily improve January 2011 revolution. Egypt has embarked on stepping down of to around US$17 in 2015, mainly due to structural reforms a dramatic political transition with the stepping former President billion at the end implemented in July 2014 (increasing and/ down of former President Hosny Mubarak, the Hosny Mubarak, the of September 2014 or enacting taxes and streamlining energy appointment of an interim caretaker government, appointment of an (equivalent to subsidies. th. and the dissolution of Parliament. The Egyptian interim caretaker about 3 months The high deficit and government borrowing people demands were summarized in “bread, government, and of 2014 projected needs has also led to the crowding out of private freedom and social justice”. The Supreme Council the dissolution of merchandise sector credit. Banks opted for purchasing of Armed Forces (SCAF) assumed executive and Parliament. imports). less risky, high-yield Government bonds and legislative powers until the Parliamentary and xxii Financial Development and Inclusive Growth Executive Summary xxiii The Egyptian people Presidential elections were concluded, and a new the lack of corrective actions. The overall budget Egypt’s fiscal demands were constitution was put in place. The prolonged deficit reached 13.7 percent of GDP in 2013, up situation has been summarized in political transition and frequent changes in prime from 11 percent a year earlier. However, fiscal deteriorating “bread, freedom and ministers, and cabinet ministers contributed aggregates are likely to temporarily improve sharply since 2010 social justice”. to the delay and uncertainty about policies and in 2014, mainly due to the exceptional Gulf aid due to weak real directions, including those related to or affecting packages, and the one-off transfer of government growth, adoption of the financial sector. In June 2012, the Muslim deposit worth Egyptian Pounds (LE) 30 billion populist measures, Brotherhood candidate Dr. Mohamed Morsi won from the Central Bank of Egypt (CBE) to the and the lack of the presidential election. Treasury. Actual figures for the first nine corrective actions. After a year of very little progress made to months of 2014 indicate a lower overall deficit of The overall budget respond to the Egyptian people’s aspirations and 7 percent of the year’s projected GDP compared deficit reached 13.7 failure to introduce a more inclusive political to a deficit worth 10 percent a year earlier. percent of GDP process, including the leftists, liberals, and youth The high deficit and government borrowing in 2013, up from that had helped bring him to power, president needs has also led to the crowding out of private 11 percent a year Morsi was removed in the wake of massive sector credit. Banks opted for purchasing earlier. However, demonstrations protesting the dire economic less risky, high-yield Government bonds and fiscal aggregates are and political situation in Egypt. The protestors Treasury bills that represent 41 percent of the likely to improve in demanded early presidential elections after Morsi banking system assets, accounting for 40.0 2014, mainly due to The sluggish one year in office. The Egyptian military forces, percent of GDP, leaving little loanable funds the exceptional Gulf growth reflects headed by Marshal Abdel Fatah El Sissi, then available. Claims on the government to-total aid packages. poor performance the Minister of Defense and Military Production, domestic credit have increased to 60 percent, by manufacturing issued a 48 hours ultimatum to the president while claims on the private sector credit dropped and construction to respond to the demands of the protestors to 37 percent in June 2013, as opposed to 54. sectors, in addition On July 3, 2013, the Egyptian Military force Starting 2014, with the exceptional to contraction in convened with various political parties including financing from the Gulf trickling in, reserves the petroleum and Salifst party, representatives of Al-Azhar and increased to above US$17.5 billion at the end However, with the tourism sectors. the Coptic Church, and announced suspension of of April 2014 (equivalent to about 3 months of election of El-Sissi as the constitution, appointment of the head of the 2014 projected merchandise imports). In tandem, the president in June constitutional court, councilor Adly Mansour, the exchange rate appreciated during first half 2014, the economy is as an interim president, and conduction of early of 2014 before it started to slightly depreciate to expected to stabilize, presidential elections. A roadmap was announced reach LE 7.15 per US dollar by end May 2014. and recovery would and has been in progress. Two and a half years However, a parallel market premium that had be witnessed as the after the revolution of January 25, 2011, Egypt emerged by end-2012 due to foreign exchange government moves is undergoing major political, economic and rationing—is still persistent. The relative forward with the social transformation with the amendments to improvement in Egypt’s external conditions reform program, the 2012 Constitution approved in a referendum prompted rating agencies to upgrade Egypt’s including that the held on January 14–15, 2014, which saw a 38.6 sovereign rating and outlook. In November 2013, financial system percent turnout and a 98.1 percent approval rate. Standard and Poor’s raised Egypt’s long- and becomes more The presidential election took place in May 2014, short term foreign and local currency sovereign inclusive, a key with Marshal Sissi elected as a new president credit rating to ‘B /B’, with a ‘stable’ outlook. contribution to for Egypt. Parliamentary elections are expected Fitch also upgraded Egypt’s outlook to ‘stable’ in economic growth. after the Sumer of 2014. January 2014. Egypt’s fiscal situation has been However, with the election of El-Sissi as the deteriorating sharply since 2010 due to weak president in June 2014, the economy is expected real growth, adoption of populist measures, and to stabilize, and economic recovery is likely as xxiv Financial Development and Inclusive Growth Executive Summary xxv the government moves forward with the reform existent mortgage finance market, as well as, The ambitious program, including making the financial system strengthening the regulatory and supervisory reform program of more inclusive, a key contribution and reform to frameworks governing the financial sector. the financial sector restoring economic growth and making it more Phase II (2009–2012) focused more on enhancing launched in 2004 inclusive. access to finance, and building a more inclusive witnessed smooth and competitive system. It aimed at improving implementation financial intermediation after achieving stability driven by the benign The Financial Sector Reform Program under the previous phase. The ambitious reform international The financial The financial sector, prior to 2004, was program of the financial sector launched in economic conditions sector, prior to 2004, dominated by state-ownership and an absence 2004 witnessed smooth implementation driven in addition to was dominated by of competition. The banking sector, the major by the benign international economic conditions commitment from the state-ownership financial intermediary, constituting over in addition to commitment from the Egyptian Egyptian authorities, and an absence of 95 percent of the financial system’s assets, authorities, and the relative political stability and the relative competition. suffered from heavy government intervention, witnessed during those years as opposed to Phase political stability. weak creditor rights, and a compliance-based II of the reform program, which was interrupted regulatory and supervisory framework. This significantly at its early stages with the January resulted in relatively low and unproductive 25th, 2011 revolution. credit, negligible innovation and a large stock Overall, the reform program produced of non-performing loans (NPLs). A relatively positive results. For the first time in recent small insurance, mutual fund and contractual history, the banking sector became majority- savings sector, underdeveloped bond, and almost owned by the private sector and open The banking sector, non-existent mortgage markets, thin trading in to competition. The banking sector was the major financial equities, weak corporate governance, and poor consolidated, and the number of banks was intermediary, financial infrastructure, characterized the non- reduced from 57 to 39 banks. State-owned constituting over bank sector in Egypt. The limited size of these banks were subject to financial, operational, and 95 percent of the non-bank intermediaries contributed to the institutional restructuring leaving a stronger financial system’s absence of long-term savings and the overall and more competitive sector. The Central Bank On the non-bank assets, suffered from limited access to finance. Ancillary financial of Egypt (CBE) also worked on strengthening front,reforms heavy government firms, such as stock brokerages, specialized the corporate governance of the banking system entailed the intervention, weak non-depository lenders (including leasing and designing a Basel II framework customized restructuring of the creditor rights, companies and microfinance lenders) and rating to the Egyptian banking system. On the non- insurance sector, and a compliance- agencies were present, but remained relatively bank front, reforms entailed the restructuring of including reducing based regulatory underdeveloped. The financial institutional the insurance sector, including reducing public public ownership; and supervisory infrastructure and the legal and regulatory ownership; overhauling the legal and regulatory overhauling the framework. framework were woefully deficient. framework; establishing a new mortgage finance legal and regulatory The Egyptian authorities launched in system; and deepening and strengthening the framework, 2004, a two-phase financial sector reform capital markets At the same time, the financial establishing a new program aiming at enhancing the stability institutional infrastructure was improved mortgage finance and soundness of the system, which would be significantly, evident in the creation of the first system; deepening increasingly private sector-led, able to contribute private credit bureau and the establishment of a and strengthening more effectively to Egypt’s growth performance. safe, secure payments system, among others. the capital markets. Phase I (2004–2008) focused mainly on All this improved the financial sector’s reforming the banking sector, restructuring the resiliency to the global crisis and the lengthy insurance and pension systems; strengthening transformation of the political regime since the the capital markets, developing the almost non- revolution, and helped it weather the crisis. xxvi Financial Development and Inclusive Growth Executive Summary xxvii The reforms did not lead to improvements in Developments and Challenges in the financial intermediation, and was accused of Banking Sector catering to large, well-established firms. Small An additional macro-financial issue of The CBE closely and medium enterprise (SMEs) did not fully concern is the potential “crowding-out” of credit monitored and reap the benefits of these reforms, the country to the private sector by government borrowing. supervised all banks had no legislative body for almost three years, The crowding-out, accompanied with weak to ensure that any which negatively affected legal reforms and the appetite for borrowing given the overall uncertain financial weaknesses passage of laws that were crucial for improving economic environment and the security situation, are addressed in financial intermediation and enhancing access to led to a decline in the credit to the private sector a timely manner, the marginalized groups and underserved areas. to 37 percent in June 2013, from 50.7 percent in and undertook To a large extent, this issue was compounded January 2011. regularstress testing. by macroeconomic instability—increased The CBE closely monitored and supervised government deficit and huge borrowing from all banks to ensure that any financial weaknesses the banking system since 2008 as a result of are addressed in a timely manner, and undertook the global crisis, and the lengthy uncertainties regular stress testing. The loan quality and of the transition to a new political regime after profitability indicators was expected to be affected January 2011. by the slowdown in economic growth, capital Financial Although sectoral analysis shows that outflows, and a rise in interest rates associated intermediation has there is no liquidity crisis in the banking sector, with the political uncertainty. An increase in been low, as evident MSEs have limited access to finance. Financial NPLs in the banking system is a likely result in the loans-to- intermediation has been low, as evident in the of the contraction in economic activities and the deposit ratio that loans-to-deposit ratio that declined from 50 turmoil following the revolution. A key sector declined from 50 percent in 2011 to reach 46 percent in January that has been significantly affected is tourism, percent in 2011 to 2014. Moreover, there is lack of term funding, while construction, mining, and manufacturing reach 46 percent which especially hampers sectors that are the have also suffered. Yet actual indicators prove in January 2014. main creators of jobs, such as manufacturing. the exact opposite as a clear decline in NPLs Moreover, there is This is compounded by the increase in the ratio from approximately 10% in 2012 to 9.1 in lack of term funding, banking sector’s risk aversion, as evidenced in the 2013 due to write offs conducted by bans under which especially decline of private sector credit-to-GDP from 36.1 their normal course of action. Consequently, the hampers sectors percent in June 2009 to 27.5 percent in January recent bank performance indicators that show that are the main 2014. MSEs suffer disproportionately from low little change in the loan portfolio quality or creators of jobs, such financial intermediation, and are offered limited profitability indicators, almost three years after as manufacturing. financial products. A recent Investment Climate the shock. Rapid Assessment Survey (2012) reveals that However, this light, it is crucial to ensure only 11 percent of micro enterprises and 17.4 that an adequate macro-prudential regulatory percent of small enterprises have bank loans, framework is in place. In particular, bank as opposed to 38.2 percent of large enterprises regulators may need to account for bank ownership (Figure 3), of these surveyed firms, more than structure in developing an early warning system 70 percent raise concerns regarding the surge that would alert them about potential problems in the cost of finance post revolution. As a in the banking industry. Most important is result, they often resort to alternative sources of to adopt a financial inclusion strategy, which finance, relying on personal savings (79 percent) would promote access to finance, especially to or inheritance (15 percent) to raise capital, while previously marginalized segments of the society. only four percent access the formal market. . Central Bank of Egypt understands the positive effect of financial inclusion and its importance xxviii Financial Development and Inclusive Growth Executive Summary xxix More generally, the on financial and economic stability, and banking investment in the private sector nor greater lack of certainty sector soundness. Efforts are exerted to access to finance occurred. regarding future understand the major concerns and problems that Major challenges confronting Egypt in Major challenges government hinder financial inclusion. Accordingly financial further developing its equity market include confronting Egypt in policy, combined inclusion takes a high priority on the CBE’s top the absence of a sufficient supply of tradable further developing with ambiguity management’s agenda in order to take all the securities as well as the marginal role played its equity market about government necessary actions to increase financial inclusion by institutional investors. Although mutual include the absence commitment, can levels specially related to SMEs finance. funds in Egypt have grown considerably in the of a sufficient supply adversely affect the past decade, from 22 funds with LE 3.9 billion of tradable securities situation. under management in 2001 to 91 funds with as well as the Development of the Non-bank Financial Sector LE 66 billion under management in February marginal role played 2014, these funds are not significant investors by institutional Non-bank financial sector reforms have in equities. Over 90 percent of all mutual fund investors. been slow to be implemented due to a variety of assets are invested in short-term debt or finance reasons. The move to a full-risk based supervisory instruments. Growth has been concentrated approach at Egyptian Financial Supervisory in money market mutual funds (MMMF), as Authority (EFSA) has been disrupted. The opposed to equity that did not grow in terms of management that followed has been overwhelmed assets under management relative to MMMF. by the volume of complaints and accusations related to the insider trading, minority In that regard, it is critical to expand the shareholders’ rights, and lax enforcement of supply of shares listed on the EGX. This could regulations. This has contributed at that time be accomplished through the government listing to the delays in non-bank financial institutions a portion of its asset holdings, increasing the (NBFI) reforms. However, in August 2013 a new number of shares of government entities already Chairman has been appointed, the third since listed and increasing the free float threshold for EFSA inception, together with a newly appointed existing and prospective listed companies. In board an aggressive regulatory reform program order to increase the role played by institutional has been adopted, culminating in significant investors; the respective oversight authorities changes to numerous laws, executive regulations should review their asset allocation guidelines and decrees, at an unprecedented pace. to enable entities such as insurance companies and pension funds to invest a portion of their Equity Market. On the non-bank front, assets in equities; and finally, perform a and in specific for the capital markets, the comprehensive analysis of the adverse impact on authorities established two funds (i) Investor market liquidity and efficiency that has resulted Protection Fund, which insures investors against from certain regulatory requirements that are any illegal activity by brokerage companies such intended to mitigate market volatility. A few as fraud, trading without investors consent; of these requirements include, limitations on however, it does not cover any losses arising from intra-day and margin trading, a prohibition on normal trading activities; and (ii) the Settlement short selling, a statutory prohibition on brokers Significant Guarantee Fund that ensures the timely engaging in proprietary trading, and price limits achievements settlement for any transaction conducted through and trading halts. It is worth noting that it was were achieved in the Egyptian Exchange (EGX) in case any party announced that effective end of July 2014, such government debt defaulted on the transaction. This ensured less precautionary measures will be removed. markets while the defaults for any stock market transaction and timely settlement of all transactions however, The few months leading the mid 2014 non-government neither greater financial system credit to witnessed EFSA’s issuance of new listing rules, segment remained and overhauled executive regulation of the relatively nascent. xxx Financial Development and Inclusive Growth Executive Summary xxxi Capital Markets law, introduction of exchange small companies; fourth, create a rationalized traded funds (ETFs) in addition to a new real CSD mechanism for both government and non- estate investment funds regime. government fixed income securities. Fixed Income Market. Despite progress Insurance and Pensions. Although Although the made in the government debt markets, the non- the Egyptian insurance sector was opened to Egyptian insurance government segment remained relatively nascent. foreign competition in 1998, it did not include sector was opened to By December 2010, the government yield curve the necessary supervisory capacity building; foreign competition had been lengthened to 7-years, rollover risk development of the necessary supporting in 1998, it did not had been significantly reduced and secondary infrastructure; and the installation of include the necessary market trading in the government bond market management in the state owned insurers capable supervisory was gradually developing. This was additionally of operating in a competitive market place. The capacity building; supported by plans to upgrade and harmonize main emphasis in the first generation reforms development of the the existing segmentation of the clearing and adopted in 2004. Hence, carried out between 2004 necessary supporting settlement platforms between T-bills at the and 2008, was mainly to restructure the state infrastructure; and CBE and T-bonds at Misr for Central Clearing, owned insurance sector and build supervisory the installation of Depository and Registry (MCDR). capacity. This period witnessed the mandatory management in the Although certain Although certain regulatory hurdles could split of life and non life insurance, additionally in state owned insurers regulatory hurdles be improved, limited market development has early 2014 EFSA allowed insurance companies capable of operating could be improved, been caused by two structural bottlenecks: the to contract asset managers to manage their in a competitive limited market dominance of banks as the main funding source funds. This move aimed at allowing insurance market place. development has at relatively low rates because of excess liquidity, companies to benefit from professional money been caused by and the need to consolidate government bond management capabilities. Additionally, EFSA two structural markets as a price reference in the long end of authorized marketing of insurance policies bottlenecks: the the yield curve. To address these challenges, a via post office branches along the same line as dominance of prioritized set of key recommendations, include: bankassurance. New rules for insurance brokers banks as the main (i) increasing the efficiency and liquidity of the have also been adopted by EFSA. funding source at money markets; (ii) resuming the pre-revolution The private supplementary pension relatively low rates program to consolidate the government bond’s sector continues to experience unprofessional because of excess yield curve, which will involve efforts in the management and a number of plans that are liquidity, and the primary market and the secondary market heavily underfunded. Actions taken to date need to consolidate (eliminate de facto primary dealer (PD) monopoly, have been largely of a diagnostic nature, government bond introduce an electronic trading platform, create although a draft law has been produced to enable markets as a price a securities lending facility and impose and the supervisory entity to effectively do its job reference in the enforce quoting obligations on PDs); and (iii) and to require the appointment of professional long end of the yield establishing corporate bond market development fund managers. To address these challenges, a curve. as a priority. prioritized set of key recommendations include: In this regard, a steering committee setting up of a central database to collect Motor comprising relevant government agencies in close Third Party Liability (MPTL) exposure and consultation with market stakeholders should be claims, passage of the Private Pension Law to established. The focus of this committee should strengthen EFSA’s ability to supervise private include, upgrading primary market rules along pension funds, ensure properness of the fund with developing a hybrid market model aimed management, upgrade EFSA’s enforcement at non-bank institutions, moving from a merit capacity to risk rate insurers and private to disclosure based primary market regime, and pension funds to take appropriate enforcement explore available options to facilitate access by action. xxxii Financial Development and Inclusive Growth Executive Summary xxxiii Mortgage Market. Creating a vibrant cumbersome property registration process mortgage lending market was one of the delaying of the execution of a secured lending authorities’ key priorities over the past decade. system based on property. The installment loan The government introduced a number of reforms, system provided by real estate developers also including setting the legal and regulatory poses many problems for lenders as well as for framework, the establishment of a mortgage the mortgage market acting as an incentive to liquidity facility, the setting up of a fund to delay the subdivision of their plots into individual Despite the support low and middle-income housing, and titles thereby making mortgages impossible to financial leasing streamlining property registration through secure until the whole development is complete. industry’s relative a nationwide mapping and titling program. Moreover, funding mortgages is constrained by cumulative growth These building blocks have helped in gradually EMRC’s inability to create a bridge between the and the favorable developing the mortgage sector in Egypt. Despite capital markets and the housing market. The developments in the increase in the number of mortgage finance cost of funds for mortgage finance companies and the market since To help improve companies, they still account for a small share banks is a serious flaw that exists in the Egyptian the issuance of access to formal of lending due to inadequate availability of long- deposit market with deposits being largely price Law 95 of 1995, home ownership term funds and delays in registering property inelastic, making it difficult for EMRC or indeed leasing remains by low and middle titles in the new urban communities. other capital market funding mechanisms to relatively small and income households, compete with much less expensive deposit based underutilized in To help improve access to formal home the government has funding. Egypt. ownership by low and middle income households, in the past provided the government has in the past provided Strategic interventions to support an a range of subsidies, a range of subsidies, through a plethora of efficient, robust and better equipped mortgage through a plethora special programs. Many of these public housing market entail the authorities to review of special programs. schemes continue to involve large government developers financing and regulation of developer subsidies. The Affordable Housing Program was installment loans with the aim of creating a safer launched in 2010, which aimed at expanding and more sustainable system; develop regulatory the residential mortgage market and increasing measures to better monitor maturity mismatch access to mortgage loans for low and middle- risks to curb the strong reliance on the deposit In order for the income households in order to improve housing base for long term lending, and reduce systemic leasing industry to affordability. This program that aimed at risks in the market. A key reform is to improve reach its potential improving the targeting and efficiency of property registration, and a move towards and develop further, subsidies by linking subsidies to affordable ‘general boundary’ principles, which would yield a number of short- mortgage loans. efficiency improvements and a much more rapid term measures need In February 2014 the Central Bank of roll-out of the systematic registration program. to be considered. There are a number of reasons Egypt announced a mortgage loan initiative for Most importantly is to expand and progress the underlying the low and middle income earners by allocating 10 Affordable Housing Program that would yield Egyptian mortgage billion Egyptian pounds to banks over a period major social benefits, as well as economic benefits market’s relative of 20 years at low price to be relent to low income through job creation. underdevelopment. earners at 7% and to middle income earners at 8%. Financial Leasing. Despite the financial The cumbersome The initiative should play an important role in leasing industry’s relative cumulative growth property registration boosting the construction and real estate sectors and the favorable developments in the market process remains as well as availing housing units at affordable since the issuance of Law 95 of 1995, leasing the fundamental prices .CBE has announced this initiative under remains relatively small and underutilized in obstacle. its corporate social responsibility role. Egypt. There are several constraints facing The mortgage market remains relatively the leasing industry that have inhibited its underdevelopment, mainly due to the growth and ability to achieve its full potential. xxxiv Financial Development and Inclusive Growth Executive Summary xxxv In order for the The most important inhibiting factors include: assets, for an equivalent to US$7.9 billion, leasing industry to (i) the scarcity of long-term funding; (ii) the accounting for less than one percent (0.7 percent) reach its potential difficulty of repossessing assets associated of total global Islamic finance assets, which is and develop further, with the inadequate enforcement of ownership very small. Banks are the main source of Islamic a number of short- rights and the delays in the collection of overdue finance in Egypt. term measures need payments; (iii) legal obstacles that create unfair In order for Islamic finance to further Enhanced access to to be considered. disadvantages to leasing and create unnecessary grow in Egypt, special laws for the introduction finance necessitates barriers to the expansion of the sector; (iv) the and practice of Islamic banking (Islamic that banks be able need for a sounder institutional environment Banking) must be put in place. Such laws would and willing to “move to operate within, particularly through the facilitate the operation of Islamic Banking side up the ladder” in establishment and development of more by side with conventional banks. There needs to terms of individual effective registry procedures; and (v) the lack be an adequate supply of qualified staff for the risk-taking, and risk- of understanding of the sector and the limited continuing expansion of the Islamic banking based supervision information and data available on it. industry and for proper risk management. must accompany In order for the leasing industry to reach Improving risk management is very important as this development its potential and develop further, a number of Islamic products are becoming more complex and of financial short-term measures need to be considered. sophisticated with financial innovation. Given intermediation. First, the definition of leasing inLaw 95 of the specific nature of risk, Islamic banks need 1995 must be modified to contain a clearer, a specific risk management approach. Reserve more precise definition that differentiates this requirements in this case should be relatively In order for Islamic transaction from others including property higher to cater to the potential significant default finance to further hire or rent to prevent abuses of tax benefits risk as well as to prevent depositors’ losses in case grow in Egypt, and double taxation. It would also be of great of poor performance and rapid capital outflows. special laws for the benefit to amend the law to allow for leasing introduction and for non-commercial purposes. Furthermore, it is vitally important for the industry that the Financial Sector Integrity and practice of Islamic Economic Growth banking must be put private credit bureau moves forward with the establishment of its moveable assets registry. In Banking Supervision. A thorough reform in place. the long-term, there is a need to secure long term of the regulatory and supervisory framework funding needed to grow exponentially. The bond was an integral part of the reform program, as a and asset-backed securities markets need to be result of which the banking sector has emerged further developed in order to extend the average as more efficient and transparent, financially maturity of leasing contracts and better serve sounder, and better equipped to manage the potential and existing clients. Furthermore, a risks inherent to its activities. Enhanced stronger judicial system, which is able to enforce access to finance necessitates that banks be foreclosures and ensure the efficient and effective able and willing to “move up the ladder” in repossession of assets in case of default, is also terms of individual risk-taking, and risk-based key to developing a more supportive regulatory supervision is accompanying this development environment for leasing. of financial intermediation. With regard to the issue of diversification in bank lending, limits Islamic Finance. Egypt has, marginally, to bank exposures to a single client and its due to the minor size of Islamic banks and its related parties, and to the parties related to operations compared to he whole sector, been the bank itself already encourage competition involved in the recent expansion of Islamic and diversification in bank lending. There is finance.. Egypt is ranked the fourteenth in terms also a need to establish a stronger linkage of countries with Shar’ia compliant financial xxxvi Financial Development and Inclusive Growth Executive Summary xxxvii between management of these exposures and of collateral; and third, the banks must be . . . Banks must progress with access to finance. For instance, provided an appropriate incentive structure that be provided an approval of new branches could, in part, depend encourages them to move into higher reward/risk appropriate on the bank’s performance regarding large lending opportunities. This can only be achieved incentive structure exposures. CBE is already giving the priority through greater competition, based on market- that encourages them to the approvals on opening branches in remote oriented corporate governance. to move into higher In regards to areas outside greater Cairo and Alxandria, reward/risk lending facilitating SME accordingly to CBE existing regulations on opportunities. opening branches. Furthermore, the system of Financial Institutional Infrastructure This can only be financing, there is strong evidence that loan classification, collateral, and provisioning Financial Market Infrastructure. achieved through the development must be reviewed from the perspective of access With regard to well designed and enforceable greater competition, of SME financing to finance given that it affects banks’ credit secured transaction rules, there are many based on market- has been hampered decisions. Specifically, greater flexibility in the weaknesses in the legal framework and its oriented corporate by the existence of collateral regime is needed to facilitate access to enforcement, such as the lack of real estate governance. a large informal finance. This would apply to SMEs, in particular. title registration. these weaknesses are sector where In regards to facilitating SME financing, there entrenched and long standing, and call for companies operate is strong evidence that the development of SME greater flexibility and novel approaches, without proper financing has been hampered by the existence of such as a “register-able” property mortgage documentation for a large informal sector where companies operate finance based on an “interim” real estate title tax evasion purposes without proper documentation for tax evasion registration, which could form the base for and thus are not purposes and thus are not bankable. Moreover, mortgage collateral and its registry. Another bankable. Banks are from a corporate mindset and need to significant gap with secured transactions, shift to the SMEs financer requirements relating which need to be addressed, is the lack of a to credit origination, follow up, and monitoring legal and regulatory framework for the use of a such sector. and registration of a broad range of movable Although, CBE requires banks to property collateral. Furthermore, the existing create SMEs unit in each bank, and SME’s bankruptcy procedures continue to focus portfolio has increased since the exemption exclusively on liquidation, and need amending. reserve requirements on SMEs portfolio. Egypt has made significant advances in Understanding the Three overarching factors must be examined: the availability of reliable credit information, a shortcomings of the first, the broad regulatory infrastructure must key requirement for soundness and facilitating status quo including be conducive to SME lending. This calls for greater access to finance, but more can be done. pre January 2011 minimum accounting standards manageable The obligation to obtain an I-Score report before reforms in Egypt is for SMEs, credit bureaus specializing in SME a bank can extend credit should be applied in key to approaching assessment, efficient legal enforcement of creditor other financial institutions as well. Furthermore, reform. and borrower rights in the case of transactions one priority should be to ensure that the fees of with SMEs, and specialized SME credit rating the credit bureau do not discourage microfinance agencies; second, prudential regulations cannot, institutions from becoming members of I-Score even unintentionally, be biased against the and using its credit information, and some form smaller enterprises. This calls for the banks to of fee subsidy could be considered. Two priorities be allowed to take on exposures to SMEs based would be the creation of a central registry for on a much broader choice of possible collaterals. both immovable and movable collateral along As already mentioned, this would require a with the creation of a SME rating agency, with new legal framework for movable collateral, possible government support to mitigate the supported by a centralized registry for all types deterrent effect of rating fees. xxxviii Financial Development and Inclusive Growth Executive Summary xxxix The prevailing Entry and exit rules that promote greater experience offers several models and policy choices legal framework competition should incentivize the banks to for consideration by Egyptian policy makers. constrains the cost broaden their lending activities. In this regard, Collateral legislation is poorly enforced. The Central Bank of and terms of finance. the conditions for approval of new branches Property rights registration and titling issues Egypt should develop Some laws are poorly gives greater weight to the prospects for make it difficult for firms, especially SMEs, incentives that written, especially increasing access to finance in the location being to use land assets as collateral. Even when encourage banks to those regarding considered, by making the local density of SMEs collateral is registered, there is no information seek an international secured transactions, an important variable in the decision, and giving on its value. This inadequate legal and judicial credit rating, for bankruptcy, and priority of branches approval to remote location system has resulted in uncertainty and high cost, instance by making settlement of disputes outside the greater Cairo and Alexandria. Going making banks reluctant to lend or instead opt it a condition for The prevailing forward, ending the moratorium on new banks to over collateralize their lending. Shortcomings banks to undertake legal framework and promoting the market-oriented behavior in rules for secured transactions have hindered certain types of constrains the cost of state-owned banks, are priorities, as is the access to finance. Egyptian law recognizes three borrowing. and terms of finance. introduction of a full-fledged banking resolution major forms of security, mortgage, pledge, and Some laws are poorly regime. A uniform, limited, and funded deposit business charge, all of which are governed by written, especially insurance scheme would not work due to negative rules that have shown various shortcomings in those regarding religious connotation. actual practice. secured transactions, Legal Framework. Understanding Governance and Transparency. With bankruptcy, and the shortcomings of the status quo including respect to reliable financial reporting and settlement of pre January 2011 reforms in Egypt is key auditing, there is a need to include in the banks’ disputes. to approaching reform. The prevailing legal quarterly reporting requirements information framework constrains the cost and terms of on the structure and concentration of the banks’ finance. Some laws are poorly written, especially shareholders, and on the loan concentrations those regarding secured transactions, bankruptcy, reflecting the largest borrowers, given the and settlement of disputes. Moreover, the court relevance of this information to the incentives for system, though well reputed for its impartiality enhancing access to finance. Furthermore, with and independence, suffers from several drawbacks the increased significance of brokerage, mortgage Policy actions for that keep it from helping expedite debt collection finance, and financial leasing subsidiaries further reform and resolve other financial disputes. The and affiliates, banks are required to quarterly should begin introduction of Specialized Economic Courts in reporting of their consolidated operations as well. with improving 2008 did not result in having specialized courts macroeconomic There is a requirement to have separate for financial institutions or specialized judges stability—a risk management and audit committees. Greater with adequate knowledge of financial market necessary but not conformity between CBE and EGX governance risks. There is difficulty in discussing specific sufficient action for disclosure requirements should encourage reform concepts in the absence of well-articulated financial deepening, banks to list. In addition, the Central Bank of and comprehensive policy objectives to be made by increased credit to Greater conformity Egypt should develop incentives that encourage the new government. Yet it is important for policy the private sector, between CBE and banks to seek an international credit rating, for makers to appreciate that fundamental changes and increased access EGX governance instance by making it a condition for banks to are needed. This is far from straightforward and to finance. and disclosure undertake certain types of borrowing. is not risk free. These changes relate to reforming requirements, the law on secured transactions, bankruptcy through further strengthening of CBE law and the functioning of the court system. Macroeconomic and Financial Stability Such changes should aim at reforming the laws, The main challenge for policymakers in requirements, should regulations and procedures governing each Egypt is to design a framework that ensures the encourage banks to matter and not an element thereof. International continued independence of the CBE. This implies list. xl Financial Development and Inclusive Growth Overview of the Financial Sector 1 the importance of better coordination between fiscal and monetary policy to anchor expectations. This independence is needed to ensure the ability to influence inflation expectations and maintain them within the inflation target range. Policy actions for further reform should begin with improving macroeconomic stability—a necessary but not sufficient action for financial deepening, increased credit to the private sector, and increased access to finance. Other possible actions include further reductions in the risks of a systemic financial crisis and increased market discipline, by continuing to improve financial supervision and the early warning of financial indicators, and by establishing a legal framework for intervention if need be. 1. Overview of the Financial Sector There is a momentum This will lead to, greater intermediation for reform and an of funds to the private sector, more inclusion, appetite for change; and more financial services to the public at it is crucial to tap lower cost. Other possible actions would increase on this opportunity competition in the financial sector and improve at such a critical access to credit—these include providing a The Egyptian economy continues to be adversely affected by the ongoing transition time. legal basis through a new law for micro-credit political unrest. Economic activity started to pick up in the second half of FY14, financial institutions and extending the coverage as the government accelerated its stimulus spending, but growth is still feeble of I-Score to small borrowers. This will also entail at 2.2 percent in 2014 (well below potential), similar to growth rates realized in having a more transparent policy for entry of “fit the previous two years. The sluggish growth reflects mainly contraction in the and proper” banks, easing restrictions on bank petroleum and tourism sectors. On the demand side, net exports remain a drag branching, increasing the use of the networks of on growth whereas real investment started to recover meagerly towards the end the Post Office, and encouraging greater use of of the year with accelerated disbursement of the stimulus package and adopted the existing licenses for mobile banking. accommodative polices backed partially by the Gulf aid packages. In addition, the In conclusion, the Egyptian revolution has Gulf States –Saudi Arabia, United Arab Emirates and Kuwait– pledged around resulted in many positive outcomes, one of which US$24 billion in financial aid to Egypt since July 2013, of which around US$17- is the desire and power to change and reform 18 billion has already been received in 2014. institutions. There is a momentum for reform and The revolution, and its associated risks, had various negative an appetite for change; it is crucial to tap on this implications on the financial sector. The widening fiscal deficit has led to opportunity at such a critical transition time. the crowding out of private sector credit. Banks have opted for purchasing Enhancing the policy dialogue and consultations less risky, high-yield Government bonds and Treasury bills that represent 41 with all stakeholders, including civil society, percent of the banking system assets, accounting for 58 percent of GDP, leaving government officials, Parliamentarians, political very little loanable funds available. All this has contributed to an increase forces, academia, private sector, donors, and in unemployment and poverty rates. Unemployment is on the rise, reaching development partners will ensure the continuity 13.3 percent in Q2 2014, up from 8.9 percent in Q4 2010. The poverty rate also of reforms. increased to 26.3 percent in June 2013 up from 25 percent in June 2011 and 21.6 percent in June 2009. Not only has economic growth been well below its potential, it has failed to create sufficient job opportunities. Moreover, growth 2 Financial Development and Inclusive Growth Overview of the Financial Sector 3 benefits have not been inclusive, creating grievances and unrest among many agencies were present, but remained rather undeveloped. The banking sector segments of society. Given such environment, governance and transparency dominated the overall financial system in 2003, as banks accounted for 130 remain pressing issues. According to the World Bank Worldwide Governance percent of GDP and 95 percent of financial sector assets. Indicators, weak governance, privileged lending, lack of a level playing field, The banking sector has historically dominated Egypt’s financial weak regulatory framework and unequal access to markets have contributed system. In its present form, the Egyptian banking system represents a to limited economic opportunities, an underdeveloped private sector, and product of multiple transformations that occurred over roughly the past have ultimately hindered job creation. two decades. This is reflected in the transition from a banking system, Moreover, Phase II of the Financial Sector Reform Program (2009– largely dominated by foreign banks, to a system that is predominantly 2012) that aimed at improving the soundness and stability of the financial Egyptian and dominated by state-owned banks. The 1970s witnessed the sector was interrupted. In addition to the urgency of cash availability at banks beginning of a new era of liberalization where banking sector activities were throughout the governorates and villages following the closure, the CBE had opened to private capital, both foreign and domestic. This move towards to respond to critical matters, such as capital outflows, international reserves, greater financial system liberalization and enhancement of its overall foreign exchange, the inflation rate, and overall macroeconomic policies. competitiveness was accelerated in large part by the launch of the Economic Given the prolonged political transition, and certain policy inflexibility Reform and Structural Adjustment Program (ERSAP) in 1991, of which one on both the fiscal and monetary sides, uncertainty prevailed and capital very important component was financial liberalization. This was followed by outflows persisted. By February 2013, international reserves had fallen to a period of very limited reforms until 2004 when a comprehensive financial US$ 13.5 billion, covering less than 3 months of imports before picking up sector reform program was launched, aimed at enhancing the soundness and again to reach around US$ 17 billion as of end September 2014 thanks to the stability of the financial sector. exceptional capital flows with a magnitude of more than US$ 18 billion from At the start of the reform program in 2004, the banking system had 57 the United Arab Emirates (UAE) Saudi Arabia and Kuwait so far. banks, of which seven were state-owned, namely, the four largest commercial On the non-bank front, EGX ceased trading since the end of January banks—National Bank of Egypt (NBE), Banque Misr, Banque du Caire, and 2011 to the end of March 2011. Egyptian Financial Supervisory Authority Bank of Alexandria; and three specialized banks—Egyptian Arab Land Bank (EFSA) and EGX resorted to unprecedented measures to curb stock price (EALB), Industrial Development Bank of Egypt (IDB), and Principal Bank volatility. They implemented measures such as narrowing circuit breakers for Development & Agricultural Credit (PBDAC). In addition, the state also that halt stock trading for a period of 30 minutes from ±10 percent to ±5 owned substantial shares in 23 joint-venture banks that accounted for around percent. Furthermore, price limits were narrowed from ±20 percent to ±10 20 percent of the system’s deposits and assets. percent. Trading hours were reduced to three hours during the curfew before Although the banking sector assets and deposits were large, large resuming the normal trading hours (four hours). Additionally, arbitrage public sector deficits and debt, pervasive state ownership of financial opportunities for stocks traded via GDRs on international stock markets institutions, heavy intervention in money markets, weak creditor rights, and on EGX were limited down significantly to control any suspicious capital and a compliance-based regulatory and supervisory framework resulted in outflows. Additionally, EFSA allowed mutual funds to amend their redemption relatively low and unproductive credit, negligible competition and innovation, policies and timing as deemed needed by them. These were among the many and the emergence of a large stock of NPLs, mainly in the state-owned banks. measures the authorities had taken to address the risk associated with the Prior to the 2004 reforms, specialized banks operated in an ambiguous January 25th revolution. policy framework—financial institutions versus development agencies. Three specialized banks accounted for about six percent of Egypt’s bank deposits Financial Development and Inclusive Growth and about 45 percent of Egypt’s branch network (with PBDAC accounting for almost all of these). These specialized banks were used to channel subsidies The Financial Sector Landscape Immediately Preceding Phase I (2004–2008) to agriculture, housing (to both developers and households), and small and of Reforms medium enterprises (SMEs), through both ceilings on interest rates and The elements of the financial sector landscape immediately preceding non-recovery of principal.1 All three specialized banks were significantly the reform program in 2004 were as follows: a banking system that is lacking overstaffed, even when taking into account the small size of its individual competition and not adequately capitalized, a sizable stock exchange, and deposits and loans. In addition to its banking activities, PBDAC was an a relatively small insurance, mutual fund and contractual savings sector. implementing agency for the import, distribution and marketing of products, Ancillary financial firms such as stock brokerages, specialized non-depository and crop purchases for the Ministry of Agriculture. However, the issuance of lenders (including leasing companies and microfinance lenders) and rating ‘Central Bank, Banking System and Money Law 88 of 2003’ set the foundation 4 Financial Development and Inclusive Growth Overview of the Financial Sector 5 for the ambitious reforms. The law introduced several critical improvements, large enterprises. The low activity of the primary market contrasts with a including complete independence of the CBE, stronger prudential regulations relatively active secondary equity market. Due to fast-rising stock prices and and enforcement powers, higher minimum capital requirements, and despite continued delisting of illiquid stocks, market capitalization to GDP principles for loan settlements and workouts. It also discontinued the special was 87 percent at the end of 2004. treatment of state-owned banks to enhance competition, and asserted the right The insurance sector’s assets accounted for less than three percent of of private sector parties to own shares in state-owned banks. Nonetheless, GDP in 2004. Although the sector was opened to foreign competition in 1998, these measures were insufficient to address the effects of pervasive state the absence of appropriate regulation, the necessary capacity building and ownership and the ineffectiveness of the financial markets. the presence of a dysfunctional state-owned insurance sector, these reforms The non-bank financial sector in Egypt was characterized by yielded limited benefits. The private pension sector was also small, with underdeveloped bond, insurance, and mortgage markets, thin trading in assets of less than three percent of GDP. Private pension funds were mainly equities, weak corporate governance, and poor financial infrastructure. voluntary occupational schemes primarily covering public sector workers and Egypt’s financial system was, and still is, mainly bank-based, with banks operating on a defined benefit (DB) basis with weak governance, regulation constituting over 95 percent of the financial system’s assets—accordingly the and supervision. The insurance and contractual savings sector is small when contribution to growth by the non-bank sector has to date been minimal. compared to the size of the economy. Although penetration has been higher Overall, Egypt’s non-bank financial sector was very small and underdeveloped than in other countries of the region, insurance and pension products have before the launch of the program. yet to gain broad public appeal. Only a small percentage of the working Capital markets in Egypt were thin prior to the launch of the reforms population participated in retirement plans. Furthermore, the sector had not in 2004. Of the 1,000 companies listed on the stock exchange approximately yet effectively channeled resources to the private sector. half did not trade, market capitalization amounted to only 35 percent of The insurance sector was largely state-owned prior to 2004, with the GDP, and the turnover ratio was extremely low at 10 percent. The share four largest insurers (including one reinsurance company) majority state- of government debt issued at market prices and traded was very small. owned and accounting for approximately 70 percent of total premiums. The The average maturity of traded government debt was very short (180 days new foreign entrants in the insurance sector (particularly life insurers) grew or less) and the long-term government bond market was very small and faster than both domestic insurers and voluntary pension funds. However, illiquid. Private fixed-income instruments were negligible. The development while foreign life insurers have been able to make inroads, the largest of capital markets in Egypt remained below potential, especially in terms domestic insurers seem determined to maintain their share of the market. of primary markets. While the secondary capital markets were active, new The non-life sector was hardly developing at all, and non-life reserves were capital market issuance-both bond and equity-have been very limited. Little not a significant source of incremental long-term funds. The success of the new external financing has been made available from either the equity or bond foreign entrants to the insurance sector reflected product innovation, mainly markets and to the extent there is such financing, it goes to the largest firms. in investment-linked life products (often denominated in hard currencies), and The bond market in Egypt is poorly developed, with few outstanding bonds, efficient distribution (bancassurance). It is clear that the major institutional very limited new issuance, and low levels of trading. investors were keen on expanding the universe of investment opportunities; The equity market as a source of investment financing is limited in however, they were confronted with various regulatory and institutional Egypt. There have been only a few corporate-bond and public-equity offerings constraints. in recent years. The total value per year of new issuances in Egypt averaged Mortgage finance. Prior to 2001, mortgage market developments and 1.2 percent of GDP between 2001 and 2004, compared to 6.0 percent and access to mortgage loans in Egypt were in general, severely impeded by the lack 13.6 percent for Chile and Korea respectively. The primary market is much of a conducive legal regulatory and institutional framework, inadequate access to smaller than those of high-performing emerging markets such as, Malaysia, long-term funding, cumbersome property registration procedures, lax collateral and Taiwan, and even below what would be expected based on Egypt’s income enforcement and cumbersome foreclosure procedures. The banking sector over level. While there have been more equity issues than corporate bonds, many the past decade has offered little formal mortgage finance to households. Some were public offerings or sales of government shares in large state-owned developers have been providing term financing under deferred installment sales companies, which do not add to capital formation. Funds raised through contracts, but these have not offered secure nor favorable conditions for borrowers. corporate bonds were even less than those raised through equity financing. In 2001, the Real Estate Finance Law, Law 148 of 2001, was issued, setting the The corporate bond market is nascent and largely dominated by commercial legal and regulatory framework for a mortgage market in Egypt. In February banks. There were no bond issuances in 2003, and three bond issuances in 2014 the Central Bank of Egypt announced a mortgage loan initiative for low 2004. Access to international capital markets is limited to financial firms and and middle income earners by allocating 10 billion Egyptian pounds to banks 6 Financial Development and Inclusive Growth Overview of the Financial Sector 7 over a period of 20 years at low prices to be relent to low income earners at 7% all the non-bank regulatory institutions and spinning off the functions of and to middle income earners at 8%. The initiative should play an important role financial leasing and factoring from GAFI and create the Egyptian Financial in boosting the construction and real estate sectors as well as availing housing Supervisory Authority (EFSA) and per Law 10 of 2009 governing the non- units at affordable prices .CBE has announced this initiative under its corporate bank financial markets and institutions. social responsibility role. The legal and information infrastructure for the financial system was Moreover, housing affordability has not improved because loan maturities deficient. The credit information systems were very poor. There was only the were too short and there was a lack of long-term financing. Until 2001, only some public credit registry at the central bank, which did not have accurate or timely individuals buying houses in Egypt were able to obtain financing, and this would data on the clients’ credit worthiness, and the threshold was (LE 50,000–) The not be in the form of mortgage loans. The most common finance arrangement was legal framework did not allow for the establishment of a private credit bureau, and the deferred-installment system, by which the developer sells a house and is paid the related credit information was restricted to banks only. NBFIs did not share, by a down payment of around 10 to 25 percent of the purchase price, followed by nor did they have access to clients’ creditworthiness information located at the installments over a period ranging from four to eight years. The title is formally Credit Registry Department at the CBE. Overall, there was lack of transparency transferred when the last installment is paid. Under this system, the purchaser in corporate accounting and auditing standards. pays a significantly higher rate of interest and higher repayments than if they could have secured a loan on the property. The system also ties up the funds of developers, who would rather invest in new projects, and can be constrained by Box 1.1: The Role of State-owned Banks and Government Intervention an adverse cycle of real estate markets. In general, the system prevents many in Credit Allocation from entering the housing market, and only represents a second best to a genuine residential mortgage market. Abundant evidence warns against financial regulatory strategies that give official agencies excessive power over the allocation of capital even when the alleged goals of Mortgage finance has also been constrained by poor and cumbersome these powers are to enhance the safety and soundness of credit allocation. For example, property registration procedures. Limited titles have been registered in there are frequent calls for policies that funnel credit to lower-income households the past, mainly due to a costly and time-consuming registration process. and smaller enterprises in the name of inclusive growth. Again, research indicates Inadequate collateral enforcement and cumbersome foreclosure procedures that powerful groups often hijack such policies and use them to promote their own is another key challenge. The repossession of real estate (notably through interests rather than to expand the economic opportunities of the society as a whole. eviction) in the case of a borrower’s default was a difficult if not impossible Whether it is developed or developing economies, state-owned, government-controlled challenge (unsecured lending). Although some of these problems have largely and state-protected banks are associated with slower growth and less rates of economic been addressed through the enactment of the Real Estate Finance Law 148 of development. Moreover, these government-influenced banks often lend the bulk of their funds to politically connected firms, not to the poor and economically disenfranchised. 2001, the effectiveness of enforcement remained untested, as lenders were to pursue their legal remedies until there was greater certainty that collateral There have been several findings suggesting that the government-owned banks could be recovered through the judicial system. stymie inclusive growth and work to help the politically influential. Cross-country Regulatory setup. Prior to Phase I (2004–2008) of the Financial experience has shown that government-owned banks favor firms with politically Sector Reform Program, regulators governing the NBFIs were scattered connected executives, but—and this is a critical distinction—privately owned banks between the different line ministries. The Capital Market Authority (CMA) do not; private banks do not lend disproportionately to politically connected firms. line ministry was the Ministry of Foreign Trade; the Egyptian Insurance Furthermore, private banks lend relatively more to small and medium-sized enterprises than government banks, while government-owned banks lend comparatively more to Supervisory Authority (EISA) line ministry was the Ministry of Planning; large firms. Thus, government-owned banks are not expanding access; rather, they the Mortgage Finance Authority (MFA) line ministry was the Ministry are supporting large, politically connected firms. Credit from government controlled of Housing and Urban Development; and the other non-bank financial banks flows disproportionately to politically important regions. These are regions where activities, such as financial leasing and factoring were regulated by the there is an election. Officials use the banks to maintain or obtain political power, not General Authority for Free Zones and Investment (GAFI). The consolidation to expand access to credit. Analyzing the characteristics of the borrowing firm and the of the regulatory setup was taken on two phases. Phase one was to combine traits of the lender in developed countries, shows that government-owned banks in Italy all these regulatory bodies under one line ministry, namely the Ministry of charge lower interest rates to large firms than their privately owned counterparts, but Investment, to ensure the speed and ease of communication and coordination do not charge lower interest rates to comparable small firms than do private banks. amongst these regulatory bodies from the one hand, and the consistency of Furthermore, firms pay lower interest rates in localities where the local government- owned bank’s chairperson has the same party affiliation as the ruling political party. reforms and policies to be adopted between the different sectors on the other hand. The second step of setting up the regulatory framework was to merge 8 Financial Development and Inclusive Growth Overview of the Financial Sector 9 Phase I (2004–2008) of the Financial Sector Reform Program Similarly, cross-country comparisons indicate that direct government involvement The main pillars of the first generation reforms (2004–2008) focused in credit allocation, either through government-owned banks, directed credit mainly on reforming the banking system, as well as strengthening the programs, or powerful regulatory guidance on credit allocation, breeds corruption supervisory framework; reforming the insurance and pension systems; in the lending process and lower quality financial services, and hence curtails strengthening the capital markets; and developing the mortgage finance inclusive growth. Direct government involvement in the allocation of credit tends to increase the flow of capital to the politically connected, limiting opportunities market. and retarding economic activity. Dinc (2005) further emphasizes that in several In the banking sector, the reform program aimed at reducing in the countries, there are cases where politicians use government-owned financial state ownership and management of banks, and increasing competition by institutions to maintain positions of power by increasing their lending in the lead privatizing one of the four state-owned commercial banks;2 divesting state- up to elections. Empirical evidence reveals that government-owned banks increase owned banks’ shares in joint-venture banks; and consolidating the system their lending in election years relative to private banks. Again, government-owned through mergers and acquisitions of small and weak banks,3 by enforcing banks are not necessarily used to promote inclusive growth: they are used to ensure stricter prudential regulations.4 The remaining commercial state-owned that incumbent officials remain in power. banks underwent financial, institutional and operational restructuring. This Although there are sound economic theories for government-owned banks, directed included the settlement of more than 60 percent of the state-owned enterprises’ credit programs and policies to encourage the flow of credit to particular ends, these (SOEs) NPLs in state-owned commercial banks, reaching settlements of 90 programs in practice frequently go awry. For example, governments might have percent of private sector NPLs, and recapitalization through retaining capital superior information about the social returns related to particular investments and gains realized on the sale of non-core assets and investments. In parallel, are able to internalize positive social externalities. Thus, government programs there was an in-depth program of improvement in information technology, could enhance social welfare. Similarly, problems with very high costs of finance, risk management, governance, and staff skills. This allowed these banks to contract enforcement and collateral requirements might prevent capital from operate on a commercially viable basis in increasingly open and competitive flowing to high-return endeavors. Under such conditions, governments can play markets, without running the risk of incurring new NPLs. The result of these a catalyzing and signaling role in financial markets. Moreover, private financial institutions might find it more difficult than governments to diversify some risks, reforms was a substantial strengthening of the balance sheets of these banks, suggesting that government credit or guarantees could foster a more efficient validated by the resiliency of the system throughout the global crisis and an allocation of capital, including extending contract maturities. In addition, during improvement in returns on capital and assets. financial crises government-owned banks could play an important countercyclical Concerning capital markets, deepening and strengthening the role and help prevent a credit crunch. However, in practice, well-intentioned efficiency of capital markets was a key objective of the first generation government interventions are frequently captured by the political and economically reforms. Reforms since July 2004 included measures to improve liquidity powerful and used to increase their slice of the economic pie, not to increase the in the equity market,5 create a sound basis for securitization, build the slice of others or the size of the pie itself. institutional investor base through separate reforms of insurance, investment funds and pension funds, and further strengthen the supervisory framework. Other measures included: the introduction of International Financial Main Components of the Financial Sector Reform Program Reporting Standards (IFRS) for listed firms and securities companies in Acknowledging and confronting the challenges in the financial 2007, as well as international auditing standards (IAS); the issuance of sector, and its potentials, the Governor of CBE, and the Minister of regulations improving capital adequacy and risk management standards for Investment launched in 2004 a far-reaching and comprehensive two- securities firms; approval of an amendment to the Capital Market Law by phased financial sector reform program (2004–2012) that was a central the Parliament in 2008; simplifying the fragmented EGX listing schedules component of a broader reform program. Its objective was to foster and abolishing the special treatment of SOEs; and the issuance of a Decree the emergence of a sound, efficient, and diversified financial system, on takeovers and public tender offers. In 2008, a stock exchange for SMEs increasingly private sector-led, that could contribute more effectively to was established, the NILEX. The securities regulator made gains in terms of Egypt’s growth performance. The reforms that the Egyptian authorities building its own capacity to supervise and monitor financial intermediaries have undertaken over the past years were supported by The World and market activity. Regulatory obstacles to the establishment of investment Bank through technical support and advisory services from development funds were also eased. partners, including the USAID, EU and African Development Bank The government debt market also developed, as indicated by the (AFDB); based on international best practice. increase in tradable debt from 20 to 36 percent of total debt, and the increase in average maturity from 120 days to 2.1 years. The debt management 10 Financial Development and Inclusive Growth Overview of the Financial Sector 11 unit created at the Ministry of Finance in 2001 has followed a strategy Figure 1.1: Number of Primary Lenders Extending Mortgage Loans that entails an increase in the share of tradable debt and increases in debt 14 maturities; it has published an auction calendar and conducted its issues through the PD system introduced in 2001. In the insurance industry, the main focus of the first generation 13 reforms was rebuilding the balance sheets of the state-owned insurers and restructuring them to achieve operating efficiencies6. An Insurance Holding Company (IHC) was created, and the two major direct insurers 12 and the state reinsurer were merged, leaving the smallest direct insurer independent in order to facilitate future specialization into life and non-life. 11 Substantial efficiencies have been achieved, reserves have been significantly strengthened, and a new generation of management introduced. In addition, a strategy to deal with the property portfolio was agreed upon and directed 10 investments were realized or transferred. The state-owned insurers’ (SOI) FY09 FY10 FY11 FY12 FY13 total market share, as measured by gross premium, fell from 83 percent to 53 percent during the restructuring while profits increased in nominal terms by Source: EFSA. 67 percent, assets under management increased by 64 percent and three new Strengthening the regulatory and supervisory apparatus and life and two non-life Takaful insurers were registered. the financial infrastructure was a major underpinning of the program. Concomitant with the restructuring, action was taken to staunch The CBE intensified its strengthening of regulation and supervision huge real losses being incurred in the compulsory Motor Third Party substantially under the new Governor. This strengthening included not Liability (MTPL) portfolio and to convert the insurance supervisor and only higher minimum capital requirements and other measures that led industry association from control entities to, respectively, a modern risk to the consolidation of the banking system into fewer, stronger banks, but based supervisor and a proper industry representative body. The financial also improvements in on-site and off-site supervision, movements toward performance of the third party motor vehicle market was significantly risk-based supervision, and efforts to improve banks’ risk management and improved through actuarially determined price increases and claims capping. governance. Moreover, an intensive program was conducted to upgrade CBE’s Other parallel developments included the development of a strategy to build banking supervision and shift it from compliance t a risk based supervision relevant human capital, including in the actuarial profession. Overall market into heavy technical assistance program conducted to upgrade the staff. performance was improved through a 50 percent reduction of stamp duty on Internal restructuring dividing the sector into 7 different department and non-life insurance premiums, an increase in minimum capital levels and the the set up of 3 new department namely: Regulations department, Macro- authorization of corporate brokers. Reflecting these policy actions relevant prudential department and Basel II implementation department. metrics were sustained or improved in the face of high inflation rates, which Significant improvements also occurred in the institutional framework are inimical to insurance and pension sector development. and financial infrastructure during the financial reform program. The legal On mortgage finance, the government worked on developing an framework for a private credit bureau was established. A law was passed for enabling environment for a modern residential mortgage market that will specialized economic courts and a substantial effort was made to train the allow most of the burden of housing finance to be shifted away from the judges in economic issues. Moreover, the CBE appropriately began its efforts government budget and onto the financial markets and the private sector. to modernize the payments system with changes in policies, regulations and One of the central goals of the first generation reforms was to create a oversight and improvements in existing arrangements that reduced processing vibrant mortgage lending market. A number of major reforms have been times for payments. The CBE also launched a real time gross settlement undertaken to achieve this. The government started to prepare a mortgage payments system (RTGS). law, setting the legal and regulatory framework. The enabling environment also included the policies, institutions and systems necessary to facilitate Phase II (2009–2012) of the Financial Sector Reform Program the emergence of an efficient, low risk residential mortgage finance system While the first generation of financial reforms focused on the in which mortgage lenders compete on a market basis to make mortgage stability and soundness of the financial system, in January 2009 the finance available to Egyptian households on economically attractive terms government launched Phase II (2009–2012) of the Financial Sector and conditions. Reform Program that focused more on enhancing access to finance, 12 Financial Development and Inclusive Growth Overview of the Financial Sector 13 the implementation of Basel II and sound governance practices. The surveillance capacity to preserve the improvements many countries have objective of this reform program was to build a financial system that achieved in access to finance. Within this context and parallel to improving is more inclusive, competitive and effective in financial intermediation, the efficiency of the banking sector through the financial and operational with sound banking and NBFIs and that is driven by the private restructuring of state-owned banks, the CBE has been making substantial sector. Banking reforms focused on strengthening the regulatory and improvements to micro prudential and macro prudential regulation and supervisory framework as well as governance structure. On the non- supervision to support the stability of the financial system. These efforts bank sector, the government’s second-generation reforms were designed focused on three main areas: (i) strengthening the risk-based supervision to create NBFI markets that are diversified and well-balanced, show of banks in implementing the Basel II framework , (ii) enhancing macro healthy growth, display resilience when faced with shocks, and facilitate prudential analysis by conducting routine stress tests and preparing a expanded access. This also encompassed continuing some of the reforms Financial Stability Report, and (iii) the implementation of sound governance initiated during Phase I of reforms, which were not fully completed, such practices of banks. as developing NBFIs. Concerning capital markets, the second-generation reforms also The third focused on reforming the insurance and pension sectors, focused on developing the markets that contribute to enhancing both access and improving the efficiency of the capital market to expand the reach of and stability. It aimed at promoting competition among banks, encouraging the non-bank financial sector to remote and underdeveloped areas. The them to go down market, and making new information and instruments fourth included measures that strengthened the regulatory and supervisory available allowing for further gains in long-term financing. The government framework for the non-bank financial sector to enable further expansion of was committed to improving the regulatory regime for investment funds access to finance through NBFIs. The fifth comprised measures to improve and other collective investment schemes (CIS). The reforms also aimed the financial infrastructure and the legal framework, with the objective of at providing additional protections to investors’ investment funds by enhancing the financial stability and safety of the payments system, and issuing EFSA Decree 88 of 2009 that required investment funds to use an extending payment access to low income and rural households. independent fund services company to perform back-office functions and On the banking sector, reform measures that aimed at enhancing the calculation of the funds’ net asset value (NAV). the efficiency of state-owned commercial and specialized banks in financial For insurance, key measures included enactment of Insurance Law intermediation and widening access to financial services through extensive 118 of 2008 separating the life from the non-life insurance portfolio, putting branch networks. One major component of the second-generation reforms compulsory MTPL insurance onto a sound long term financial footing, was the continuation of the operational and financial restructuring of the developing a sound and sustainable banc-assurance model, fostering the state-owned banks, starting with the commercial state-owned banks (NBE, development of micro-insurance (largely working with MFIs) and increasing Banque Misr, and Banque du Caire). The restructuring process began in public awareness of the role and value of the insurance sector. 2005 and focused on three critical areas: (i) risk management functions, Strengthening the regulatory and supervisory framework including NPL management; (ii) human resource functions, and alignment was a major underpinning of the second-generation reforms. The CBE of organization and general management functions; and (iii) information reforms included actions that strengthened the resiliency of the financial technology and management information systems. While this process system through improving the regulatory and supervisory architecture continued, the second-generation reforms also included setting profitability, of the banking sector. The aim was to ensure the sector’s soundness and efficiency and corporate governance benchmarks by the CBE to be revised lay the foundation for broader access to finance NBFIs including the quarterly, to assess the three banks’ management performance. The capital market, the stock exchange, insurance services, mortgage finance, second-generation reforms put special emphasis on state-owned specialized financial leasing, factoring and securitization. With regrads, to NBFIs, banks. The approach to the specialized banks was similar to that for the the first step in this program was the issuance of Law 10 of 2009 that commercial banks: starting with independent audits. would regulate non-bank financial markets, institutions and instruments Strengthening of the regulatory and supervisory framework of the and has consolidated the regulatory bodies of non-bank financial sector banking sector remained a critical part of the second-generation financial through the establishment of the EFSA—the integrated non-bank reform program. A credible and independent regulator is the necessary financial supervisor. EFSA aimed at strengthening the legal framework anchor of an effective and resilient financial system that is able to prudently for NBFIs and markets and implementing a relatively advanced risk-based expand access to finance, especially in an environment where Egypt will supervision system for insurance and pension funds. The unification of be more integrated into the global financial system. The global financial these regulatory and supervisory objectives under EFSA, coupled with crisis demonstrated the need for strong micro and macro prudential unifying the Auditors Oversight Board to cover all non-bank institutions, 14 Financial Development and Inclusive Growth Overview of the Financial Sector 15 aimed at enhancing the transparency and reliability of financial reporting Figure 1.3: NPLs-to-Total Loans in the non-bank sector. Regulating pension funds was also one of the main 16 objectives of the reform program. 14 On improving the financial infrastructure, the second generation reforms included key measures related to the payments system, including 12 a RTGS and an automated clearing house (ACH); the new regulatory 10 framework for mobile phone payments. Developing a timely and accurate credit worthiness database and credit information system at the private 8 credit bureau was a key priority. All these measures aimed at attaining a 6 financial institutional infrastructure that would be more conductive to better 4 financial intermediation. 2 Achievements and Main Outcomes 0 On the banking sector, the reform program produced positive FY09 FY10 FY11 FY12 FY13 results. For the first time in recent history, the banking sector became Source: CBE. majority-owned by the private sector and open to competition—through the Key profitability and efficiency indicators of the state-owned commercial privatization of the fourth largest state-owned bank, Bank of Alexandria; banks have been substantially improved, due to financial and operational and the divestiture of 94 percent of state-owned bank shares in joint venture restructuring since the onset of the financial sector reform program. The three banks. The banking sector was consolidated, and the number of banks was state-owned commercial banks—NBE, Banque Misr, and Banque du Caire, which reduced from 57 in 2004 to 39 banks by 2009. Other achievements include account for about 46.1 percent of bank assets—have substantially improved their the financial, operational, and institutional restructuring of the remaining profitability, efficiency, and capital7. The reported ratio of capital-to-risk-weighted three commercial state-owned banks. The operational restructuring of the assets in all three banks in 2013 substantially exceeded the required 10 percent state-owned commercial banks targeted three critical areas (human resource level. Moreover, as of end-2011, ratio of provisions-to-NPLs is approximately 86.50 development, risk management, and information technology), as well as the percent. The NBE has increased efforts to recover on private sector NPLs, and adoption of a detailed program for capacity building in banking regulation Banque Misr that has inherited Banque du Caire’s NPLs, continues to dedicate and supervision. significant efforts to collection8. Moreover, all three commercial state-owned banks are now managed in line with good lending practices and a significant Figure 1.2: Capital Adequacy of the Banking System proportion of NPLs is a legacy of the past except Banque du Caire for which the 16.5 operational restructuring was delayed, the two other state-owned banks are now 16 competing at par with the private banking sector9. Post the January 25th revolution, CBE has strengthened corporate 15.5 governance in the banking system by issuing Corporate Governance Regulations 15 on July 5, 2011. All banks, including commercial and specialized state-owned 14.5 banks, are instructed to comply with the new regulations. The principles require banks to establish relations between their management, Board of Directors, and 14 shareholders, as well as, other stakeholders with a clear definition of powers and 13.5 duties of each of them. Further, banks need to have non-executive and independent members on their Boards. Moreover, banks are required to put in place appropriate 13 committees on compensation, audit, and risk management apart from the already 12.5 existing audit and executive as stated in the Central Bank, the Banking Sector and FY09 FY10 FY11 FY12 FY13 Money Law no 88 for 2003. They are also expected to develop policies to address Source: CBE. conflicts of interest and related party transactions. According to the CBE, all banks will comply with the corporate governance regulations, including state-owned banks. The CBE has also amended the ‘Central Bank Banking System and Money 16 Financial Development and Inclusive Growth Overview of the Financial Sector 17 Law 88 of 2003’ on October 8, 2011, introducing changes regarding improving the The CBE has been involved in programs of restructuring with the CBE’s own governance, reconstituting its own board of directors to remove conflicts state-owned specialized banks, but the restructurings and recapitalizations of interests, and tightening supervisory capacity and processes. have slowed down as a result of the political and economic uncertainty post Commercial state-owned banks are now competing with private banks on a January 2011. The restructuring program with the EALB was furthest level playing field. State-owned commercial banks’ accounting methods became in along. The small, state-owned specialized Investment Development Bank line with IFRS, and their financial statements reflect net asset values (NAVs) and (IDB) has been gradually undertaking a program of financial, operational, their economic position. The quarterly balance sheets and income statements of and institutional restructuring. The merger of the small, Workers Bank the state-owned commercial banks are audited by two independent auditors, and into the IDB has delayed the restructuring of the bank. Currently there published by the banks. is visible progress in the restructuring of the bank. In 2014, post June 30 revolution, the new government put the restructuring of the specialized banks, especially PBDAC as a priorty. It is expected that a full-fledged Box 1.2: The Principal Bank for Development and Agricultural Credit operational, financial and institutional restructuring will resume in all of these banks, once the uncertainty begins to clear up now that the Although PBDAC is a relatively small bank in terms of the system assets, it plays a presidential elections have taken place. disproportionate role in rural finance. Its impact on the total banking system in the event of failure may be small because of its relative size, but its social, and political, impact will Table 1.1: Egypt—Banking Soundness Indicators (percent) be extremely high given its unique role. PBDAC’s assets and deposits represent less than Indicators FY10 FY11 FY12 2013 1 percent of total system assets, and deposits. However, of total lending to agriculture, 70 percent is provided by PBDAC. Moreover, PBDAC is the only bank that provides loans to ( percent) March June Sept Dec individual farmers. With its large network of over 1,200 branches, 46 percent of system First: Capital Adequacy total, PBDAC is overwhelmingly the bank of the small, rural village. Its role, and potential Capital Base to Risk Weighted Assets 16.3 15.9 14.9 14.5 13.4 14 13 role, in financial inclusion is highly significant. It currently mobilizes deposits from 2.7 million people, with an average savings balance of LE 10,000. Its capital is now negative Tier 1 Capital to Risk-Weighted Assets 12.7 13.3 12.9 12.3 11.5 11.8 10.8 and its operations loss-making, in part because of the culture of periodic loan forgiveness Net Worth to Assets 6.7 6.8 7.2 7 6.9 6.8 6.7 by government, non-performing loans (NPLs) are high—19.4 percent. PBDAC has been the subject of earlier reform programs, which have so far had limited impact. A recent Second: Asset Quality reform program (Rabobank) was making good progress at the time of the revolution. In Nonperforming Loans to Total Loans 13.6 10.5 9.8 10 9.5 9.5 9.1 particular, it helped improve the bank’s liquidity management capacity without which Loan Provisions to Nonperforming Loans 92.5 94.5 97.1 98.7 98.9 99.5 99.7 it might have run into serious liquidity problems during the revolution. However, post revolution reform efforts were halted and the Rabo bank was discontinued. Loans to Private Sector to Loans to Customers 80.5 81 82.2 82.9 83.6 83.2 82.7 Third: Earnings Just before the January 25th revolution, The PBDAC had restarted to undertake a Return on Average Assets 1 0.8 1 1 1 1 1 substantial program of financial and institutional restructuring, including increasing its mobilization of deposits to fund its lending, modernizing its branches and branch Return on Average Equity 14.3 11.7 13.9 13.9 13.9 13.9 13.9 structure, connecting its branches by internet, and improving its risk management. The Net Interest Margin 2.3 2.6 3.5 3.5 3.5 3.5 3.5 government had begun the process of changing the bank’s legal status to a state-owned Fourth: Liquidity commercial bank, but this was postponed with the revolution and dissolution of the Parliament. The bank also started offering new lending products after the revolution, Liquidity Ratio such as microfinance and Islamic finance products to cater to the demand of the people, Local Currency 44.7 55.6 58.4 59.7 59.6 61.9 60.3 especially farmers in rural areas. The bank continues to have a bad lending portfolio, Foreign Currencies 40.6 51.8 56.3 57.2 57 57.1 55.9 weak internal systems, and redundancy, which can be a drag on the bank’s ability to improve its efficiency and profitability. The bank has fallen short of the CBE’s minimum Securities+ to Assets 18 18.7 21.9 19.5 19 18.5 20.2 capital adequacy requirements, which resulted in the government extending support. Deposits to Assets 81 82.5 82.7 75.1 76.2 76 78.2 Because of its weakening cash income generating capacity, the bank’s liquidity ratio Loans to Deposits is likewise close to the CBE’s minimum requirement. Although restructuring of the specialized state-owned banks was at a slower pace, the PBDAC managed to improve Total 51.8 50.2 48.1 47 46.3 44.9 42 its coverage ratio from 87.8 percent in 2008, to 90.7 percent in 2011, in addition to Local Currency 44 45.7 45.8 43.7 43.1 41.4 38.5 introducing 13 products in 2011, as opposed to 10 in 2008. Yet, the bank clearly needs recapitalization and a significant operational restructuring to avoid recurring losses. Foreign Currencies 75.8 62.5 56.1 57.1 56.1 55.9 53.1 Source: CBE Database. 18 Financial Development and Inclusive Growth Overview of the Financial Sector 19 Overall, the banking system proved its soundness and resiliency in on related-party transactions) and a strengthening of investment fund regulations. weathering the global financial crisis and the immediate ramifications of the Moreover, EFSA’s staff of equity market regulation has already started to shift January 2011 revolution. More specifically, this has been attributed to the from compliance-based to risk-based supervision. That being said, both domestic successful financial and operational restructuring of the commercial state- and foreign portfolio investors would want to see greater prospects for political owned banks. certainty and economic growth before supporting higher equity valuations. Without The supervisory and the regulatory framework. The CBE has dedicated higher equity valuations, corporations will remain reluctant to move forward with considerable efforts to improve its assessment and surveillance of macro prudential initial or secondary public offerings of shares. risks. The Banking Supervision Department has set up a macro prudential unit The EFSA merger has been completed and in January 2011. The Chairman with the aim to assess and produce regular reports on major developments in was able to issue a comprehensive report covering background, establishment, the Egyptian banking sector at the aggregate level. The Banking Supervision internal restructuring plans and achievements to date. However, the move to a fully Department strengthened the macro prudential unit with the aim of preparing integrated approach has been disrupted by the departure of the first Chairman of and publishing a full-fledged Financial Stability Report, the first report of its kind EFSA. Market trading practices and governance have improved. Efforts continue in the Middle East and North Africa (MENA) region. Indeed, the macro prudential to protect minority investors from potential corporate governance irregularities, unit prepared the first Financial Stability Report at the end of 2011. However, especially from insider and related-party share trading. In May 2011, the EFSA there is a delay in the publication of the report because of political and economic Board decided to require expanded disclosure by EGX-listed companies of the uncertainty. Stress testing has become an integral part of the CBE’s systemic holdings of major shareholders (i.e. 5 percent or more), free float, Treasury stock surveillance of the banking sector. The Macro Prudential Unit has been conducting transactions, and changes in the board of directors. In addition, regulations for stress testing and standard financial soundness indicator analyses on the banking disclosure and corporate governance were augmented by EFSA post-revolution. In sector since 2009, which is also being supported by the World Bank. order to strengthen compliance of listed companies with internationally recognized Also CBE established a regulation department responsible for developing corporate governance standards and enhance transparency of equity markets, new and amending current regulations for the banking sector in accordance with EFSA reinforced the revised code on corporate governance. EFSA has added the international best practices. Moreover, the department ensures the clarity important disclosure provisions to its listing requirements through two recent of the rules and regulations issued by the Central Bank of Egypt, and avails all Decrees. EFSA also intends to add the “comply or explain” provision to its listing prudential regulations to interested parties whether inside or outside the CBE. requirements. This means that any company listing shares on the EGX would have to either fully comply with the new code of corporate governance or explain for Moreover, CBE established a department Basel II implementation which each provision why and how it deviates from the code. This reform is expected to was in charge of issuing the Basel II regulation in the banking sector. strengthen corporate governance and transparency of listed companies. On the non-bank front, the reform program entailed the deepening and EFSA Decision No. 88 of 2009 requires investment funds to appoint strengthening the efficiency of capital markets, restructuring of the insurance independent Fund Administration Companies to avoid conflicts of interest and sector (including reducing public ownership and overhauling the legal and protect investors by performing critical functions, per IOSCO best practice, in regulatory framework), establishing a new mortgage finance system and a liquidity order to protect investment fund certificate-holders from adverse actions by fund facility,10 beginning reforms of private pensions, and developing financial leasing managers. These critical functions include calculations of NAV, maintenance of and factoring. In addition, the program included developing a strategy for micro- fund records on investment transactions and certificate holders, and calculation lending through NBFIs to enhance access to finance and achieve a more inclusive of management fees and bonuses for fund managers.12 As of mid-2009, Egypt’s financial system. investment fund regulations fell short of IOSCO best practices in several regards, Regarding capital markets. Near-term capital market performance will including the potential for conflicts of interest (e.g., possible related-party be driven by political and economic developments. Confidence in Egypt’s political investment, lack of code of conduct); lack of separate directors for bank-sponsored stability, fiscal performance, and credit prospects could be expected to reverse investment funds; and limited standards on permissible advertising by investment the recent rise in Treasury bill rates and make banks somewhat more ready to funds. Prior to the revolution, the EFSA Board had submitted to the Minister of consider business lending as an alternative to buying and holding government Investment draft amendments on investment funds for the Capital Market Law debt.11 Development of a corporate bond market will remain constrained by Egypt’s Executive Regulations. The Ministry of Investment Decree No.1 of 2010 introduced lack of a reliable yield curve, which reflects among other things a lack of secondary a number of measures (such as allowing bond issuance by public authorities, trading in government securities. Looking at equities, Egypt’s regulatory regime authorization of additional rating agencies, audited projections of main financial for equities already compares favorably with other MENA jurisdictions and the ratios in lieu of pro forma financial statements) to encourage the development of authorities seem committed to implementation of recent rules (e.g., on disclosure, Egypt’s corporate bond market. This enabled a quasi-sovereign agency, the NUCA, 20 Financial Development and Inclusive Growth Overview of the Financial Sector 21 to undertake three issuances of bonds (including a 5-year term) totaling LE 7.5 Strengthening the financial infrastructure was one of the main billion during the first half of 2010.13 achievements of the reforms. The RTGS became fully operational in 2010. It has The private pension fund sector has seen little progress, partly reflecting been operating successfully since that time including during the revolution, in uncertainties as to the likely impact of the Law 135 of 2010, which proposes a combination with the ACH to continue to pay pensions to some retirees through radical restructuring of the social insurance regime in Egypt, and public pensions ATMs. The ACH became fully operational in June 2010. Approximately 2.4 in particular. This law has been frozen by the interim government and its future million payment cards have been issued to government workers and pensioners and hence impact is now uncertain. through the government payments system program. The scarcity of ATMs may become an increasingly problematic issue as more and more government In the insurance sector, the legal and organizational restructuring of the employees and pensioners begin to use this system. Government employees and state-owned insurers was completed in July 2010. Misr Life is now the only state- pensioners typically elect to withdraw cash when they are paid. A full ACH owned insurer selling life products and Misr Insurance only sells non-life products. connection between the Ministry of Finance and the CBE was established by end The establishment of pure life and non-life operations has brought Egypt into line of 2012. This connection will allow direct payments to government suppliers. with global good prudential practices (2003 IAIS ICP 6, criterion G).14 Competent Also, the National Inter Bank Switch for retail payments is now fully operational management is now in place in both the state owned direct insurers and Misr in all banks—a key development in the financial institutional infrastructure. Insurance Holding Company (the group holding company), and assets are being professionally managed by the insurers and other group companies. Post-Revolution Risks and Challenges Table 1.2: MTPL Claims Ratios by Accounting Year15 Although the reforms led to a sound and stable system, improvement in Accounting Year 2007 2008 2009 2010 2011 financial intermediation was not maintained, due to the developments associated State owned Insurers 846.8 635.2 261.1 452.3 377.9 with the events of January 2011, which led to the crowding-out of the private sector Private insurers 267.1 131.2 28.5 59.2 66.7 by the government with the budget deficit; and a weak appetite for borrowing Source: Misr Insurance Holding Company. with the overall uncertain economic environment and security situation. Credit provided by the banking sector to the government has continued its accelerated The balance sheets of both state-owned insurers are now largely repaired pace (Figure 1.4). The government’s share in total credit increased to 63 percent after approximately LE 2.5 billion of reserve strengthening over the restructuring in April 2013, up from 45.2 percent in January 2011. The private sector’s share period. The main technical challenges continue to be maintaining the stability of shrank to 28 percent in April 2013, from 50.7 percent in January 2011, which was the MTPL non-life portfolio in Misr Insurance and containing the cost of certain starting to pick up immediately prior to January 2011. legacy group life retirement arrangements that were incorrectly priced and poorly designed in Misr Life (formerly National Insurance). Although Misr Insurance Figure 1.4: Credit by Banks to the Government has significantly strengthened its own technical reserves, it discovered that it Versus Credit to Private Sector (Percentage) had inherited an enormous technical reserve shortfall when it took over National 80% Insurance’s ‘Act’ insurance claims portfolio in 2009; moreover, claims’ provisions for business written before claims were capped (under Law 72 of 2007) continue to prove to be inadequate as the claims are run off. This reflects National’s former 60% dominant role in the MTPL business and the dependence of a section of the legal profession on representing accident victims and their need to maximize returns from the old claims portfolio during its run off period. On the other hand, the 40% business written since the claims cap was instituted and premiums were increased is providing an adequate overall return to underwriters, although some categories 20% of vehicle continue to be highly unprofitable. Other positive insurance metrics are that both the life and non-life sectors have had an unexpected dividend from the revolution in that the corporate and tourist industry sectors (mainly for Strike, 0% Riot and Civil Commotion (SRCC) Insurance) and individuals (life and medical) Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 have become more conscious of risk. Reinsurers are imposing limits on the sum insured under SRCC policies and corporations are having to pay considerably more Government Private Sector for full coverage (in the past this was added ‘free’ cover under most commercial insurance contracts). Source: CBE. 22 Financial Development and Inclusive Growth Overview of the Financial Sector 23 According to Kunt, Feyen, and Levine (2012), there is enormous cross- in excess of its revenues from taxes and fees, plus its international funding country variation in private credit. For example, the median value of private from grants and borrowing, then it must borrow from the domestic economy, credit to GDP for high-income OECD countries was 114 percent in 2010, largely the banks, thereby crowding out private borrowing. In order for while it was only 33 percent in Egypt and for the median MENA country. private activity to expand, the government must allow room for bank loans While Egypt does not have a particularly low value of private credit to GDP, to the private sector for working capital and investments. This crowding it does have a very low value of private credit by domestic private banks to out will also restrict the ability of corporate and SMEs to raise capital in GDP, suggesting that the private intermediation of credit to private firms the capital market through the issuance of fixed income instruments. To is an under developed component of Egypt’s financial system. For example, the extent that private entrepreneurs with sound investments are stymied private credit by domestic private banks to GDP is about 63 percent for the from raising capital due to these credit allocation decisions Egypt’s financial median high-income OECD country, about 16 percent for the median MENA system is hindering economic growth. country, and about 4 percent for Egypt. An increase in NPLs in the banking system is a likely result of the Despite the good performance and resilience of the banking system contraction in economic activities and the turmoil following the revolution. A during the global financial crisis and the problems associated with the key sector that has been significantly affected is tourism, while construction, aftermath of January 2011 and June 2013 revolutions, various issues mining, and manufacturing have also suffered, this could have negative could arise during the coming period. Until there is clarity about the policy implications on the performance of the loans of borrowers in these sectors. directions, these issues, discussed below, may affect both the Financial Sector Concerns over transfers of property or takeovers of assets could also lead to Reform Program and, more generally, the financial sector’s ability to mobilize higher NPLs. The stress testing conducted by the CBE since the revolution resources and lend them efficiently to support sustainable development. showed that the capital cushion would be able to absorb such an increase. There are concerns of possible setbacks in reforms oriented towards The CBE is closely monitoring and supervising all banks to ensure that any private-sector led growth. Although economic research stresses that well financial weaknesses are addressed in a timely manner. incentivized, privately owned banks will tend to identify, fund, and monitor On the banking sector, there remains a risk of deterioration of the best investment opportunities across private firms, with positive banks’ resiliency and solvency, in terms of capital. The capital to risk- ramifications on economic development, sentiment regarding privatization weighted assets ratio of December 2011 was around 15.6 percent well and the sale of public assets has turned decidedly negative since the start above the 10 percent requirement. However, risk will remain, particularly of the revolution. Even the sale of Bank of Alexandria, which took place in if growth remains low for a prolonged period or government policy and October 2006, at well above its book value, has been attacked by the media. changes in the political environment lead to defaults by borrowers. Under This accompanied condemnation of certain private sector participants who populist pressure and condemnation of the private sector, the government are alleged to have benefited from improper behavior, which could lead to a may be tempted to allocate credit to sectors considered important or condemnation of market-oriented economies and private sector led growth strategic. Although such a process may seem obvious to some, experience generally. Assessment of these policies should be based on their implications world-wide has shown that ultimately, it could add to the burgeoning on the financial sector and not solely their association with the previous volume of NPLs; further limit the availability of funds to non-preferred regime. Particularly at this critical juncture in Egypt’s economy, to jeopardize clients; and require government injections of funds into the banking future development will not be in the best interests of Egyptian society. system, problems that were similar to those of the Egyptian financial In the aftermath of the revolution, commercial state-owned banks are system some years ago—prior to the Financial Sector Reform Program. facing various challenges. Due to the uncertainty of the times, lack of bankable The CBE indicated clearly that they would not allow the allocation of opportunities and the growing financial needs of the government, the state- credit on non-economic or commercially viable terms. owned banks are buying large amounts of sovereign debt that represents now On the non-bank front, despite the reforms adopted in 2004, private more than one third of their total deposits. At the same time, the loans-to- fixed-income instruments have remained negligible. Mortgage markets deposit ratios are depleting revealing an anemic economic situation. continue to be limited in both scope and activity, due to high fees and inefficient A macro-financial issue of concern is the “crowding-out” of credit to procedures for land registration, weak regulatory authority and poor access the private sector by government borrowing. The higher government deficit to long-term credit. Egypt’s capital markets remain thin. Financial leasing and the sell-off of its bonds indicate the risk of public sector borrowing and factoring continue to be underdeveloped or almost non-existent. crowding out bank lending to the private sector. The fiscal deficit is mainly NBFI reforms have been slow to be implemented due to a variety of being financed from domestic sources, through the issuance of public debt reasons associated with the revolution, including the failure to replace the that is being absorbed by financial intermediaries. If the government spends Minister of Investment. The Ministry of Investment and EFSA did not ensure 24 Financial Development and Inclusive Growth Overview of the Financial Sector 25 the effective implementation of the various reforms related to the non-bank financial sector and the sector lacked the vision to proceed with the reforms, Box 1.3: Lack of Legal and Regulatory Framework for Microfinance and was overwhelmed by the cases filed. Egypt suffers from various deficiencies that prevent further expansion of the A significant risk to insurers and pension funds in the medium term microfinance sector. Lack of a conducive legal and regulatory environment is a is that rates of investment return drop, and in the case that Misr Life state main impediment. There is no clear supervisory responsibility or framework for employee salary costs increase rapidly at the same time, adding significantly the microfinance industry. Commercial banks, which have traditionally focused on to the need to strengthen retirement fund group life reserves for certain serving large corporations and medium to high-income individuals, are supervised categories of state employees. The contribution of investment income to by the Central Bank of Egypt (CBE). Some of these commercial banks have begun to insurers’ results has already decreased (the return on investment for the downscale and cater to micro enterprises but these are limited in number. The low- state-owned insurers from 13.8 percent in 2006/7 to 9.1 percent in 2012/13 income are mostly served by NGO-MFIs for credit and are monitored by the Ministry of Social Solidarity. The two finance companies in the market (Reefy and Tanmeyah), despite improved asset/liability ratios), although steps are being taken to currently providing microfinance, operate in a legal grey zone. As a result, the counter this by, for example, moving term deposits into government paper current system suffers from a fragmented set of rules, lack of level playing field, and and reducing equity exposures. The maximum salary issue is not currently a an inadequate regulatory and supervisory framework. Growth of this sector is still problem for the management of state-owned insurers because of reasonably constrained by the lack of an enabling microfinance regulatory and legal framework high minimum salaries. Although, any moves to further reduce salary caps that is essential for strengthening the sector, encouraging its growth and allowing could see a significant loss of critical skills and experience, EFSA is likely to for further outreach. see some losses as some senior officer’s salaries have been cut substantially. In response to operational challenges faced by NGOs-MFIs, efforts have been made The state-owned insurers currently have at least double the staffing to improve the enabling environment for financial intermediation and to strengthen levels they need to operate efficiently and many staff is effectively financial infrastructure. A licensing law for all NBFIs was submitted to the Cabinet unproductive. Recent and imminent supplementary salary increases arising of Ministers in March 2010. The draft law allowed for the creation of the first from decisions taken over 5 years ago are increasing costs rapidly, and while commercial micro finance institutions (MFIs) in Egypt and would have allowed NGOs expense rates are still sustainable and competitive thanks to the scale of that are actively involved in microfinance to convert into a full-fledged MFI under the oversight of EFSA, and enable NGOs to establish an MFI arm or continue to the state insurers and branch rationalization, this trend cannot continue function as an NGO reporting to the Ministry of Social Solidarity. While establishing without affecting the long term viability of the two insurers; particularly a supervisory board with membership of CBE and EFSA. With the dissolution of the if investment returns are under pressure. DBs private pension funds will parliament post revolution; this law never saw the light. It was only in 2013, with also see funding levels reduce materially if a combination of rapid salary the appointment of a new cabinet, a new law drafted by EFSA that solely addressed increases and reduced returns continues for even a few years. the legal and regulatory framework for microfinance was presented and approved by the cabinet in May 2014. The dissolution of the Parliament has resulted in delaying the issuance of several key laws. This problem relates to the potential overload on the post June 2013 Parliament yet to be elected, which may face major political challenges in any new directions it decides to make as well as having to deal With regards to financial infrastructure, licenses for mobile payments with a large volume of pending legislation, in particular, legislation to improve provision have been issued to three banks, the Housing Development Bank, the functioning of the financial system and making finance more accessible. National Bank of Egypt and BNP Paribas Emirates NBD and their partner- This potential problem could affect the ratifications of the Microfinance mobile phone companies. The operation of systems under these licenses Law and Real Estate Law amendments to the Mortgage Finance Law and was delayed by the events of January 2011, but they are expected to begin Financial Leasing Law, and the legal changes in the PBDAC Law, all of operation soon. The Central Bank Banking System and Money Law 88 of which were delayed initially by a legislative backlog at the end of 2011 and 2003 limits deposit taking to banks licensed and supervised by the CBE. This subsequently by the dissolution of Parliament. limit means that mobile payments systems and products involving deposit- taking are required by law to go through banks; mobile providers cannot offer deposit services independently from banks, as has been done in some countries, for example, Kenya. The purpose of the law is to ensure strong supervision of deposit-takers and avoid bank collapses that would be likely to require government ad hoc coverage of deposits and to protect depositors’ rights, including the right to redeem their deposits. 26 Financial Development and Inclusive Growth Overview of the Financial Sector 27 Islamic Finance in Egypt Egypt has the longest experience of Islamic finance since it started in Egypt is ranked fourteenth Figure 1.5: Islamic Finance Penetration in 1960s, yet it is underdeveloped when compared to Gulf Co-operation Council among countries with Shari’a Selected Countries (GCC) countries, Iran and Malaysia. The growth and progress of Islamic compliant financial assets, for an equivalent of US $7.9 (percent share of Islamic banking in total banking assets in each country) finance in Egypt during the last few decades has been slow. Despite the fact billion, accounting for less Oman Indonesia that Islamic finance started decades ago in Egypt, compared to the global than one percent (0.7 percent) Egypt Turkey Islamic finance experiences, the rules and regulations governing Islamic of total global Islamic finance Pakistan Banking continue to lag behind. Political factors have been unhelpful for assets, which given the size UAE Iraq Islamic finance where it was seen at being associated with banned Islamists. of Egypt’s economy is very Malaysia small.18 This was a drop from Kuwait the initial rank of 12th during S.Arabia Bahrain the period 2006–2009 in global Box 1.4: Evolution of Islamic Finance in Egypt Islamic finance. This indicates Bangladesh 0 10 20 30 40 50 60 70 that the growth rate of Islamic The global Islamic finance industry continues its quest to boost international Source: The Banker, Maris Strategies. finance in Egypt was less than competitiveness and to build a sustainably profitable business model. Islamic Banking that of some other countries. is a growing worldwide phenomenon. The number of Islamic financial institutions has increased significantly in the Arab Countries. There are now around one hundred Islamic Islamic Banking, as a share of Egypt’s total banking assets was about four percent in 2010; Bankings and financial institutions working in the private sector. Islamic finance was this was very small when compared with many other countries offering Islamic financial less affected by the financial crisis and downturn than some parts of conventional finance, although some Islamic Bankings have been exposed to the volatile real estate markets, instruments. Islamic Banking only accounts for 3 to 4 percent ( Islamic banks’ assets and a number of Sukuk issuers have defaulted on payments. While less affected by the to total assets of the banking sector in Egypt 4.2%, and the share including the Islamic financial crisis and global economic downturn, Islamic finance faces various ongoing windows is 6.7% as 2013) of Egypt’s $193 billion banking industry. Compare that with 46 challenges, including management liquidity, compliance issuesand governance. percent in the United Arab Emirates. Egypt continues to have an extremely low Islamic Banking penetration rate when compared to other countries.It is likely that the political According to Maher Hasan and Jemma Dridi (2010), Islamic Bankings performed better factor prevented the growth of Islamic finance as it was seen at being associated with the than conventional ones in 2008 in terms of profitability, credit and asset growth. The Islamic previously banned Islamist political movements. Another reason is very likely the lack of Bankings’ profitability crunch was less than 10 percent, whereas the CB’ profitability Islamic law and regulations. There is no comprehensive Islamic Banking law apart from the slumped more than 35 percent in 2008 compared with 2007. Moreover, Islamic Bankings limited provisions made under Islamic Finance Law 48 of 1977. The licensing requirements have maintained stronger credit growth compared to Commercial Banks. The Islamic for Islamic Bankings are similar to those for CB in terms of capital requirements, liquidity Banking system’s features make its activities more closely related to the real economy. This ratios and financial reporting. These are not always accommodating to Islamic Bankings reduces its contribution to excesses and bubbles. however, as they are often placed at a disadvantage in relation to CB with regard to regulatory requirements. Moreover, there is a lack of knowledge of Islamic Banking, due to the limited Moreover, the global crisis highlighted the need to address important challenges faced by public awareness programs and marketing by the few Islamic Bankings in Egypt. the Islamic Banking industry, including: (i) the infrastructure and tools for liquidity risk management, which remains underdeveloped in many jurisdictions; (ii) a legal framework, Islamic Financial Products in Egypt: Sukuk which is incomplete or untested; (iii) the lack of harmonized contracts; and (iv) insufficient expertise (at the supervisory and industry levels) relative to the industry‘s growth. Sukuk is one of the instruments that play an important role in funding investment. Although the Capital Market Law 95 of 1992 and its Executive Regulations include A pioneering experiment of putting the Islamic principles governing financial dealings Sukuk as one of the securities that can be used to finance the economic activities, into practice was conducted in Mit-Ghamr, Egypt, from 1963 to 1967 by Ahmad El-Naggar. the implementation did not result in activation of this instrument due to the lack of This bank laid the seeds of modern Islamic Banking and pointed the way for subsequent integrated regulations for Sukuk issuance. However, in early 2012, the government undertakings.16 In 1971, the government of Egypt created Nasser Social Bank (NSB). announced that they would be issuing foreign currency denominated Sukuk or This bank provided a number of Islamic financial products, including interest-free loans certificates of deposits mainly targeting the Egyptians abroad. to the poor, student scholarships and small business credit on a profit/loss sharing basis.17 Although it offered interest free loans subject to administrative and service As part of the plan to develop and diversify the financial instruments and to increase charges, it was not specifically Islamic in terms of its ethos or products. In response to the ability of corporations and other different entities to access finance, EFSA and the lobbying by advocates of Shari’a compliant financial products, the Islamic Finance the Ministry of Finance prepared a proposal in order to provide a legal framework for Law 48 of 1977 was passed, permitting the establishment of Islamic Bankings, and their using the Sukuk as one of the financing instruments for both government and private regulation by the CBE. The Faisal Islamic Banking of Egypt obtained a license from the sector companies, and assess a fair balance of rights for each issuer, underwriter and CBE on June 14, 1979, to become the first Islamic Banking established in Egypt, shortly all participants in the capital market. The Sukuk law was ratified by the Shura Council followed by Al Baraka Bank of Egypt, which was awarded its license on May 8, 1980. (upper house of the parliament) before June 2013. 28 Financial Development and Inclusive Growth Overview of the Financial Sector 29 Even though Egypt was the first country to start Islamic Banking in Table 1.3: Islamic Banks Share in Total Banking Sector (2006-2010) 1963, Islamic Banking assets in Egypt account for a mere three percent of 2010 2009 2008 2007 2006 the total banking system in 2007. During this period, there were still only two Islamic Bankings with a branch network of 33 branches offering limited Islamic Banks 10058 8901 7850.1 7347.3 4826.3 financial products, mainly Murabaha and Mudaraba.19 During the period Total Assets Banking Sector 2144.510 1951.381 1901.546 1646.634 1322.615 2008–2010, the Islamic Bankings s activities increased, showing growth rates in assets of 10.5 percent, 14.3 percent and 9.7 percent in the years Share of Islamic 4.690 4.561 4.128 4.462 3.649 Banks (percent) 2008, 2009 and 2010 respectively. However, these growth rates were less Islamic Banks 6884 5997 5707 5102.82 3703 than those of GCC countries. It is worth noting that the government under Mubarak was hostile to Islamic finance, keen on keeping a secular country Loans Advances Banking Sector 818.675 759.394 704.625 621.043 562.767 concerned primarily with political matters rather than recognizing the Share of Islamic 8.409 7.897 8.099 8.217 6.580 relevance of Islamist groups. Although some Islamic Banking was permitted, Banks (percent) it was confined to the fringes of the banking system. Despite the fact that Islamic Banks 9046.000 8107.000 7175.000 6686.600 4357.600 Egypt had over three decades of Islamic Banking experience, Law 88 of 200, Banking Sector 1567.976 1446.916 1311.566 1141.069 987.914 Customers’ contains no provision relating to Islamic finance. Deposits Share of Islamic 5.769 5.603 5.471 5.860 4.411 The Islamic Banking industry in Egypt consists of full-fledged Islamic Banks (percent) Bankings (Faisal Islamic Bank of Egypt, Al Baraka Bank and Abu Dhabi Islamic Banks 607.000 566.000 559.800 509.800 311.400 Islamic Bank), Islamic branches, Islamic windows and certain other banks Shareholder Banking Sector 131.911 112.439 100.648 80.037 70.389 possessing an Islamic Banking license. Although Egypt has the longest Equity experience of Islamic finance, there are still many obstacles facing Islamic Share of Islamic 4.602 5.034 5.562 6.370 4.424 Banks (percent) finance. One obstacle is the lack of the rules and regulations governing Source: 1-Data information center, EMIS. Islamic Banking up until now. Table 1.4 shows the aggregate main financial indicators for the three Major Islamic Banking Players in Egypt fully-fledged Islamic Bankings. The date of the table shows that the three Banks are the main source of Islamic finance in Egypt. The Islamic Islamic Bankings achieved a moderate growth rate in financial items (Total Banking sector can be divided into three modes or groups. These modes are: Assets, Loans Advance, Deposits and Shareholders’ Equity). In addition, the ϘϘ Full-fledged Islamic banks: There are three fully-fledged Islamic Islamic Bankings (Faisal Islamic Bank of Egypt and Al Baraka Bank) met the Bankings in Egypt. These banks are: Faisal Islamic Bank of Egypt, international standards of minimum capital requirement, which is 8 percent. AL Baraka Bank and Abu Dhabi Islamic Bank. The performance of Faisal Islamic Bank of Egypt and Al Baraka Bank was ϘϘ Islamic branches: There are mainly two state-owned banks that much better than the performance of Abu Dhabi Islamic Bank because of the have Islamic branches. These banks are: Bank Misr and NBE, a weak performance of the bank before it was acquired by Islamic Bank of Abu private-owned bank, United Bank which has also recently established Dhabi in 2007 and transferring its activities to Islamic Banking activities.20 Islamic branches. The Future of Islamic Finance in Egypt ϘϘ Islamic windows: There are two banks that have Islamic windows, The pre June 2013 new Islamist parties and government have had Principle Bank for Development and Agricultural Credit (PBDAC), the development of Islamic finance, one of the key priorities in their reform specialized state-owned bank; and Al National Bank of Kuwait- agenda. According to data from Bank scope and Thomson Reuters, Egypt could Egypt, private-owned bank, both of which introduced Islamic see Islamic finance assets grow to $10 billion in 2013 from $6 billion in 2007. financial products. Moreover, there is also interest for Islamic insurance, Takaful, which makes up five percent of Egypt’s US $1.45 billion insurance market but is expected to grow dramatically.The Islamic finance industry faces several challenges. Some of the major constraints are very similar to those of CB, while others are uniquely related to Islamic finance. The most significant challenges are in the areas of regulation, supervision and international harmonization; risk management; innovation and financial diversification; and human resources. 30 Financial Development and Inclusive Growth Overview of the Financial Sector 31 On the legal framework Islamic Bankings generally operate under Endnotes conventional legal frameworks and institutional arrangements. In many cases, 1 The subsidies were covered by injections of Government funds from time to time, and external loans that these are not suitable for their operations. Although there has been over three were repaid by the Government. decades of Islamic Banking experience in Egypt, as mentioned earlier, the recently 2 The first generation reforms included the privatization of Bank of Alexandria through sale of 80 percent of the equity to Bank San Paolo (later merged with Intesa to form Intesa San Paolo). Although the privatization issued banking law does not contain provision for Islamic finance. In terms of of Banque du Caire was not part of the reform program, the government decided in early 2007 to privatize corporate governance, the ownership structure of Islamic Bankings depicts high the bank. The government’s commitment was evident in completing all the necessary steps for a strategic sale. Specifically, in July 2007, it had announced that 70 percent of the bank would be sold to a strategic concentration. This introduces the possibility of monopoly power and undue investor, and in October 2007 the government selected JP Morgan as sales advisor and received three bids influence by a few major shareholders. in May 2008. However, the sale transaction was not completed, mainly due to the price was much lower than that estimated by the evaluation committee headed by the Central Audit Agency (CAA), and the global Human resources development is another major challenge because there is financial crisis paralyzed the bank privatization world-wide. a serious shortage of scholars who possess a working knowledge of both Islamic 3 More than 94 percent of the state-owned bank shares in joint venture banks were divested. fiqh and modern economics and finance. This shortage may pose reputational risks 4 Consolidation of the banking sector was through higher minimum capital requirements and stricter prudential rules, which resulted in the exit of small and weak banks through mergers, acquisitions, and to the industry and slows down product development. Most of the managers of closure of foreign bank branches, which reduced the overall number of banks from 57 in 2004 to 39 in 2008. Islamic Bankings are not very well trained in the use of Islamic modes of finance. 5 The upward rise in liquidity reflects sustained efforts to de-list companies that do not trade or do not meet Another challenge, which is also at the global level, is that there is an issue of corporate governance requirements. The number of listed companies steadily declined from 795 at the end harmonization. Shari’a interpretation is different among countries and regions. The of 2004 to 373 at end of 2008. The delisting of small companies contributed to a rise in average market capitalization, from LE 294 million in 2004 to LE 1633 million at the end of 2008. Moreover, whereas only absence of a single deciding authority concerning the Shari’a is a major challenge 53 percent of listed firms traded in 2004, 94 percent traded in 2008. Risk management is impeded by the relatively short track record of 6 In excess of LE15 billion of non-life reserve strengthening occurred over the 3 years to June 30, 2008. Islamic financial institutions. Most Islamic Bankings active in Egypt have their 7 According to their annual reports and CBE data. transparency; corporate governance and risk management at large still work in 8 Its NPLs-to-total loans ratio is at 7.2 percent at the end of March 2012. progress. Special risks associated with Islamic finance include displaced commercial 9 Banque du Caire should have been merged with Banque Misr then privatized. For the time being, the bank is still owned by Banque Misr but it operates its activities independently from Banque Misr. risk,21 Shari’a-compliance risk, entanglement of market and credit risks in Islamic 10 The World Bank supported the development of the mortgage finance market through two different Bankings’ asset classes, heightened liquidity risk due to large maturity mismatches operations, the Mortgage Finance Project and the Affordable Mortgage Finance Program DPL. and scarce liquidity management tools, and reputational risk. 11 Highlights include: (i) EFSA has decision making, budgeting and organizational autonomy; (ii) a cadre of new younger graduates not tied to past structures and approaches has been recruited after an exhaustive In terms of product innovation, the Egyptian Islamic financial institutions are selection process and trained (including time with the Singapore Monetary Authority). New cadres of such lagging behind due to the absence of one central Shari’a board, to make decisions on individuals will be recruited on an annual basis; and (iii) an Institute for Non-banking Financial Services has been established to enable local personnel to attain international qualifications (e.g. through sitting the the Shari’a-compliance of banking products; multiple boards are active on different CII insurance exams in Cairo). levels: starting with international institutions, to country and bank levels. 12 Market participants indicate that six Fund Administration Companies are operating and performing these critical functions. This may have encouraged greater public confidence in investment funds. According to EFSA, 89 investment funds were operating by May 2013 compared to 68 in December 2009 and only 49 in December 2008. Concluding Remarks 13 Other corporate bond issuances, however, were down. During 2010, 5 corporations undertook 12 bond In conclusion, the financial sector in Egypt has evolved and gone through issuances totaling LE 5.2 billion. Thus, the combined 15 bond issuances in 2010 are down from the 22 numerous transformations as previously discussed, and has reached a point where corporate bond issuances in 2009. Unsettled market conditions presumably had some negative effect. Market participants note, however, that Egypt has yet to develop a real secondary market in government it has been resilient to a great extent in weathering the global economic and financial securities. The resulting lack of a reliable yield curve may significantly dampen investor appetite for crisis, the Euro crisis, and the implications of the Egyptian revolution. However, corporate bonds and discourage development of a corporate bond market. The Ministry of Finance has made major improvements in its primary issuance practices and development of benchmark issues. Additional it is important that the banking sector reforms proceed, focusing on attaining measures are needed to encourage secondary trading in government securities. a more inclusive system catering smaller enterprises and marginalized areas. 14 MENA is the only region where a significant number of composite insurers are still allowed to operate, Restructuring the specialized banks, especially those with huge branch networks however strict separation is now being introduced (UAE, Algeria) in some nearby jurisdictions. A partial list of G20 countries requiring separation of life and nlife activities includes the relevant EU countries the US, in the underserved governorates would be key. At the same time, promoting the Canada, Australia, Indonesia, Mexico and South Africa. growth of non-bank institutions is important in ensuring a more balanced financial 15 Claims ratio is claims cost over corresponding earned premium. sector, capable of performing the full spectrum of intermediation functions, 16 CHACHI, ABDELKADER, 2005, “Origin and Development of Commercial and Islamic Banking Operations”, diversifying risks, and the presence of a meaningful domestic institutional investor J.KAU: Islamic Econ., Vol. 18, No. 2, pp. 3-25 (2005 A.D/1426 A.H), http://www.kau.edu.sa/Files/320/ Researches/51027_21164.pdf. base that contributes to the sound development of securities markets. Egypt has - African Development Bank, 2011, Ibid. been debating fundamental issues and the economic orientation of the new regime 17 Gait, A.; Worthington, A. C., 2007, “A Primer on Islamic Finance: Definitions, Sources, Principles and needs to be clear because there is a pressing need to maintain financial sector and Methods”, University of Wollongong, School of Accounting and Finance Working Paper Series No. 07/05, 2007. market-oriented reforms, as well as sustain and promote private sector led growth. 18 This is based on the Banker’s survey of 500 organizations showing the leading countries for Shari’a The urgency to broaden opportunity without disregarding the achievements of the compliant assets as a percentage of total global Islamic finance assets. The first country is Iran with $388 past reforms is essential taking stock of the lessons learnt. It is critical to ensure billion (35percent), Saudi Arabia $151 billion (13.9 percent), and Malaysia $133 billion or (12.2 percent). that the benefits of the reform are reaped by all segments of the society. 32 Financial Development and Inclusive Growth Overview of the Financial Sector 33 19 BlomInvest Bank, 2009, “Islamic Banking in the MENA region”, Economic research department, February, www.bloominvestbank.org 20 Nasr, Sahar, 2011, “Islamic Finance in the Arab World: Challenges and Prospects”, World Bank, 2011 Cambridge Business & Economics Conference (CBEC), June 27-29 21 “Displaced commercial risk” is a term reflecting the risk of liquidity suddenly drying up as a consequence of massive withdrawals should the IFI’s assets yield returns for unrestricted investment account-holders lower than expected, or worse, negative rates of profits. 2. Banks, Economic Growth and Opportunity This chapter makes a case for further financial sector reform in post-revolution Egypt. Based on international comparisons, we show the important role that financial sector deepening and broadening can play in creating a more inclusive and more prosperous Egypt. While Egypt has undertaken impressive financial sector reform over the past decade, it has still not reaped the benefits in terms of a deeper and more inclusive financial system. We will discuss a new reform agenda to (i) expand access to finance by both enterprises and households, (ii) lengthen the maturity of financial instruments and (iii) safeguard the financial system against fragility. This will require continued macroeconomic stability and further institution building. It also implies a further redefinition of government’s role in the financial sector, but also in the real economy, increased competition within and from outside the financial system and a new regulatory approach that relies more on market discipline and allows for more innovation. We finish with recommendations for some concrete policy actions. Finance: Pro-Growth and Pro-Poor The economic development paradigm of the 1960s and 70s did not envision a meaningful role for financial sector development. Even the Washington consensus of the 1980s did not include financial sector reform as a priority apart from an emphasis on private actors and free prices. Over the past 20 years or so, however, financial sector policies have become a centerpiece in the debate on how to foster growth in low-income countries, 34 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 35 reduce stark poverty levels, and, ultimately contribute to the achievement by helping to increase incomes, financial deepening can create additional demand of the Millennium Development Goals. Even taking into account reverse for financial services, thus generating a virtuous cycle of financial and economic causation, research has established the robust positive impact of financial deepening. Moreover, many of the policies that foster financial sector deepening sector deepening on economic development. Figure 2.1 illustrates the and broadening, including legal system reforms, reforms to improve transparency conclusion of a well-established body of empirical evidence: countries with and governance and macroeconomic stability, also have a direct positive impact higher levels of credit to the private sector relative to GDP experienced higher on economic development and poverty alleviation. average annual real GDP per capita growth rates over the period 1980–2007. What are the channels through which financial development helps The effect of finance on growth is not only statistically, but also increase economic growth? While financial systems assist in pooling savings, economically significant, as the following example illustrates. Over the transforming maturity, and converting savings into capital accumulation, it period 1980 to 2007, Private Credit to GDP averaged 33 percent in Egypt, is ultimately through improvements in resource allocation and productivity but 87 percent in Thailand the cross-country comparisons illustrated in growth that finance helps economies grow more quickly (Beck, Levine, and Figure 2.1 suggests that Egypt’s real GDP per capita would have grown Loayza 2000; Love 2003; Wurgler 2000). The functions of attracting deposits 0.9 percentage points faster per year, had it had the same level of financial and investment and transforming short-term claims into long-term assets, development as Thailand, or 3.4 percent instead of the actual 2.5 percent. thereby financing investment, should obviously not be ignored; they are This would have resulted in over 50 percent higher GDP per capita in 2007. the basis for the ultimate function of finance, which is to put the savings of This is notwithstanding the financial crisis that Thailand went through in society to their best use, that is, put savings where they can reap the highest the 1990s. The graph, however, also illustrates that the financial sector has (expected) returns, thus translating into growth. Below, we will argue that not contributed as much to growth, as would have been predicted by the Egypt’s financial system has been relatively efficient in mobilizing savings, cross-country comparison, since Egypt actually achieved a higher growth though much less so in intermediating them efficiently. rate than predicted by its level of financial development and other factors Financial systems can have a transformative impact on sectoral and controlled for in this regression. This shows the limitations of our indicator industrial structures of countries. Financial deepening helps industries of financial depth, but also points to the “quality” of financial intermediation that rely heavily on external finance, but it also helps reduce the financing being an important dimension of financial sector development, that is not constraints on enterprises, particularly smaller firms (Rajan and Zingales necessarily captured by this crude indicator of financial intermediation. 1998; Beck, Demirgüç-Kunt, and Maksimovic 2005). Financial deepening thus has a transformative effect on economies by shaping industrial structure, Figure 2.1: Finance and Growth across Countries (1980-2010) distribution by firm size, and even organizational structures (Demirgüç- 0.04 Kunt, Love, and Maksimovic 2006). Financial development is also critical for entrepreneurship. Finance 0.02 provides opportunities for new entrepreneurs and fosters innovation and GDP per capita growth Egypt, Arab Rep. competition. Policies that ease enterprises’ access to external finance have been shown to help especially smaller firms grow faster (Aghion et al., 2007, 0.00 Klapper, Laeven and Rajan, 2006). A vibrant financial system can support a private sector characterized by new successful entrants gaining traction and growing quickly, while withdrawing support from failing entrepreneurs. -0.02 Access to external finance can even help in the start-up phase, though not necessarily through traditional channels. A well-diversified financial system offers different financing tools for start-ups and small enterprises. In many -0.04 developed countries, household finance, e.g. credit cards, can help finance start- -2.00 -1.00 0.00 1.00 2.00 ups, while venture capital companies are an important vehicle in financing Private Credit to GDP Other high-risk ventures. Leasing is an attractive financing tool for small and less EGY mature enterprises, as it is based on the cash flow of the financed asset, such Fitted values Source: World Bank Database. as machinery or vehicles, rather than reputation of the enterprise or the asset base of the enterprise. Factoring, the discounting of sales receivables, is The positive impact of financial development on growth does not mean that attractive for small suppliers of large credit-worthy buyers, as it does not rely growth has no influence on financial deepening and broadening. On the contrary, on information about the “borrower”, but rather on the credit-worthy buyer. 36 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 37 Financial sector development is important not only for fostering the What are the mechanisms of this poverty-reducing impact of financial economic growth process, but also for dampening the volatility of the growth deepening? In this context, it is important to distinguish between two process. As shown by Aghion et al. (2010), financial systems can alleviate different concepts: Finance and Poverty Alleviation and Finance for the the liquidity constraints on firms and facilitate long-term investment, which Poor. Recent research has pointed to a significant indirect impact of financial ultimately reduces the volatility of investment and growth. Similarly, well- deepening on poverty alleviation. By changing the structure of the economy developed financial markets and institutions can help dampen the negative and allowing more entry into the labor market by previously unemployed impact that exchange rate volatility has on firm liquidity and thus investment or underemployed segments of the population, finance helps reduce income capacity (Aghion et al. 2009). This is especially important in economies that inequality and poverty, as evidence from Thailand and the U.S. has shown are subject to high terms of trade and real exchange rate volatility. The (Gine and Townsend, 2004, Beck, Levine and Levkov, 2010). By doing so, recent crisis has shown that countries with less developed financial systems financial deepening can help achieve more inclusive growth and, also, help and less exposure to international financial markets were less affected by overcome spatial inequality in growth benefits. Recent evidence also suggests the first-round financial contagion effects of the Global Financial Crisis, but that financial deepening can contribute to employment growth in developing more heavily affected by the second-round effects through the real sector countries, a critical priority in Egypt in the coming years (Pagano and Pica, links, as their financial systems could not serve as shock absorbers (Beck et 2011). It is thus important to understand that the effects of financial deepening al., 2011). on employment and poverty alleviation do not necessarily come through the Financial deepening is not only a pro-growth, but also a pro-poor “democratization of credit” but rather a more effective credit allocation. This policy. Figure 2.2 illustrates the pro-poor effect of finance: countries with also implies that microcredit is not necessarily the most important policy deeper financial systems see poverty levels drop more rapidly. As in the case area to reap the benefits of financial deepening for poverty alleviation. of economic growth, the economic effect of financial deepening on poverty For the poor to benefit directly from financial sector deepening and reduction is strong, as again the comparison between Egypt and Thailand broadening it is important to look beyond credit to other financial services that illustrates. A level of financial development as in Thailand would have led to are needed by the poor, such as simple transaction or savings services. This is a strong reduction in poverty levels rather than the slight increase that Egypt also consistent with the distinction below between Finance for Markets and experienced over the 1990s. As in the case of the finance-growth relationship, Finance for Growth (Box 2.1). While it should be a goal to achieve access to the relationship between financial depth and changes in poverty levels is basic transaction services for as large a share of the population as possible to robust to controlling for other country characteristics, omitted variables and thus enable them to participate in the modern market economy (Finance for reverse causation. Markets), the agenda in boosting access to credit should focus on improving the efficiency of this process, replacing access through political connection Figure 2.2: Finance and Poverty Alleviation across Countries (1980-2007) and wealth with access through competition. By channeling society’s 0.04 resources to the most credit-worthy enterprises and projects, the financial system can enhance inclusive growth (Finance for Growth). Both policy areas relate to the Finance for All (or Finance for the Poor) agenda–expanding 0.02 basic transaction and savings services to a larger share of households and Growth in headcount Egypt, Arab Rep. expanding access to external finance to a larger share of credit-worthy firms and entrepreneurs. While the Finance for Markets and Finance for Growth 0.00 agendas aim for more efficient financial systems, the Finance for All agenda aims for a more inclusive financial system. -0.02 -0.04 -2.00 -1.00 0.00 1.00 2.00 Private Credit to GDP Other EGY Fitted values Source: World Bank Database. 38 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 39 What has the recent crisis taught us about the role of finance in the Box 2.1: Three Concepts of Finance growth process of countries? The Global Financial Crisis of 2007/8 and the ensuing Great Recession have put in doubt the paradigm that financial Finance for Markets relates to financial services that underlie short-term commercial deepening is good for growth under any circumstance. For students of financial market transactions, such as trade finance, remittance payments, and various types systems, the bright (growth-enhancing) and dark (instability) sides of financial of short-term credit facilities. This concept relates primarily to the financial system development go hand in hand. The same mechanism through which finance function of enabling market-based transactions within the economy and across borders. By facilitating commerce, financial systems allow the market-based exchange of goods helps growth also makes finance susceptible to shocks and, ultimately, fragility. and services beyond the immediate family and community. Finance for Markets thus Specifically, the maturity transformation from short-term savings and deposit refers to financial services for enterprises and households, thus cutting across all facilities into long-term investments is at the core of the positive impact of a possible beneficiary groups. The concept covers transaction and payment services, financial system on the real economy, but also renders the system susceptible including remittances from emigrant workers to their families back home. It covers to shocks. The role that finance has as a lubricant for the real economy likewise deposit services for households and enterprises, as well as short-term credit facilities exacerbates the effect of financial fragility on the real economy. We therefore for enterprises of all sizes, including trade credit. These basic services are provided by argue that instead of throwing out the baby with the bathwater, it is important almost every financial system in the world, even the most rudimentary ones, although at different degrees of efficiency. They are mostly provided by banks, but may also to construct a regulatory and governance framework that minimizes the risk be provided by non-bank financial service providers, including telecommunications of fragility and provides policy makers with better possibilities for managing companies. The recent crisis and the global reduction in the supply of trade finance bank failures in a way that is incentive-compatible. If there is a lesson to be underline the importance of Finance for Markets. learned in emerging markets such as Egypt from the crisis, we think it is that the growth benefits of a well-developed financial system can only be reaped Finance for Growth relates to the finance for enterprises, households and governments in a stable macroeconomic environment protected by an appropriate legal, that supports medium- and long-term activities (longer than 12 months). Finance for regulatory and supervisory framework and strong internal bank governance. Growth is finance mainly for investment purposes, and it is here that financial institutions and markets fulfill their key function of the maturity transformation of short-term liquid This implies more transparency and accountability in bank management, less claims—be they deposits or marketable securities—into long-term investment finance. direct government intervention in the regulatory and supervisory process, and Finance for Growth thus involves a key function of financial systems: pooling society’s a focus on building up mechanisms of market discipline. savings and putting them to their best use. This comprises risk management techniques and the screening and monitoring of entrepreneurs and projects. It relates to large-scale finance, including for infrastructure and agriculture, and finance for SMEs and to debt Financial System–Growing from a Low Level and equity instruments, as well as hybrid instruments, such as mezzanine debt and This section uses an array of different data to gauge the development guarantees. These services are provided by an array of institutions, including banks, and structure of Egypt’s financial system. insurance companies, pension funds, mutual funds, and private equity funds, and relate to activities on different financial markets, including stock and bond markets. Moving The Environment from Finance for Markets to Finance for Growth constitutes a major challenge for many low-income and even middle-income countries. One approach to assess Egypt’s financial system is to gauge the environment in which it operates. Following Honohan and Beck (2007) Finance for All relates to the process of expanding financial services both for markets and Beck et al. (2011), we focus on four characteristics: size, informality, and for growth to the largest possible segment of the population, including households, volatility and governance. The small scale of many developing economies small enterprises, and large firms. Finance for All overlaps with the concepts of Finance does not allow financial service providers to reap scale economies. Compared for Markets and Finance for Growth, but refers to the process by which short- and long- term financial services, including payments, savings, credit, and insurance services, to other countries in the region and other developing countries, however, are pushed out to previously un-served segments of the population. It overlaps with Egypt’s population and economy has a size that is conducive to sustaining a Finance for Markets to the extent that access to basic transaction services is being relatively diversified and competitive financial system. This is also obvious extended to all segments of the population. It overlaps with Finance for Growth to the from the variety of markets and institutions that Egypt supports, even extent that more segments of the population gain access to contractual savings services, though they are not as developed. Unlike most countries in the African while microenterprises gain access to investment finance. In discussing Finance for continent, Egypt does have relatively well developed capital markets, as we all, we refer to all types of formal financial institutions, but also semiformal financial will discuss below. Unlike other small economies, Egypt can create critical institutions such as cooperatives or savings and credit cooperatives. Finance for All has been a challenge throughout the world not only for low-income countries, but also for mass internally, including the basis for a higher intensity of competition many middle-income countries that have made substantial progress in the dimensions among financial sector providers and an active financial sector dialogue. It is of Finance for Markets and Finance for Growth. less likely to experience bottlenecks in capacity, and can afford a relatively Source: Beck et al. broad institutional underpinning for financial sector regulation. 40 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 41 The informality of large parts of the population increases costs dropping from 57 banks in 2004 to 29 in 2010. Bank supervision has undergone and risks for financial service providers: As in many developing countries, significant changes, moving from a compliance-based toward a risk-based system. informality in Egypt‘s enterprise sector is high, at an estimated 37 percent As result of the reform program, Egypt’s financial system has transformed of GDP. Egyptian Labor Market Survey Data for 2006 indicate that over 83 itself during the past decade, becoming more stable, mostly due to addressing percent of enterprises operate in the informal economy and over 70 percent loan losses in state-owned banks, increasing provisioning and capital and the of private sector wageworkers are engaged in informal activities. This high aforementioned increase in minimum capital. The NPL ratio dropped from degree of informality increases costs and risk for financial service providers, 18.2 percent in 2006 to 13.6 percent in 2010, while the risk-weighted capital- as these households and enterprises cannot provide formal documentation asset ratio rose from 14.7 percent to 16.3 percent during the same period. The and lack access to formal collateral. resilience of Egypt’s banking system to the global financial crisis reflects the Volatility on the individual and aggregate levels increases costs and improved personnel and institutional capacity, including risk management undermines risk management for financial institutions. On the individual level, and loan procedures, as well as the stronger regulation and supervision of the informality is related to high volatility of income flows, which brings us back CBE as well as limited connections with the international financial system. to the issue of informality. On the aggregate level, trade-of-terms shocks and There has also been progress in the financial infrastructure, most notably socio-political unrest are the main drivers of volatility. While until recently, the through the establishment of the credit bureau I-Score as well as improvements in macroeconomic management provided a stable backdrop for financial transactions, the payments system. Established in 2005, I-Score functions as a private (majority- Egypt has suffered from irregular bursts of terrorist attacks, which undermined owned by banks) but regulated monopoly, collecting both negative and positive the tourist sector, with negative repercussions for the financial sector. More information on all bank borrowers. In many aspects, it complies with international importantly, the 2011 revolution–while offering large opportunities for financial best practice as it is open to financial service providers beyond banks, including sector reforms as we will discuss below–has also increased uncertainty. The leasing and finance companies and microfinance NGOs. In payments, the RTGS recent political turmoil in the run-up to the elections has increased the volatility payments system became operational in 2010 and was extended by making the and made the environment for the financial sector more challenging. Automatic Clearing House operational. This reduces the problems of default in Governance problems continue to plague many private and government payments that have proved very costly in some countries, such as India. institutions in Egypt. They affect directly the ability of financial institutions In 2007, Nilex, a second-tier market, was established by the government and markets to manage idiosyncratic and systemic risks. The governance to offer funding to SMEs by offering relaxed listing rules. Nilex is meant to challenge and the related agenda contain a large number of dimensions, attract promising companies that cannot comply with the listing rules of the related to state ownership in both financial and real sector, deficiencies in the regular market. legal system, lack of transparency and accountability as well as corruption Benchmarking Egypt’s financial system. Today, Egypt’s financial and graft. The Financial Sector Reform Program discussed above has made system is relatively large, when compared to most peer countries. A significant progress in the governance agenda within the financial system, but benchmarking exercise shows a financial system corresponding to its level of the positive effects have been limited by continuing governance challenges in income per capita and other country characteristics including size, population the political area and real sector. The new political situation after the 2011 density and demographic structure. Specifically, Figures 2.3 and 2.4 show revolution and the change to a democratically elected government, however, the actual and predicted values of two aggregate financial depth indicators, offers a window of opportunity for major reforms. corresponding to the two sides of banks’ balance sheets–Bank Deposits to Financial Sector Reform Program, Phase I (2004–2008) GDP and Private Credit to GDP. The predicted value is the result of a broad cross-country regression exercise that predicts the level of financial depth Beginning in 2004, significant reforms were implemented in the context with (i) GDP per capita and its square, capturing the positive but non-linear of a Financial Sector Reform Program that included privatization of one of the relationship between income levels and financial depth, (ii) total population, four commercial state-owned banks and financial, operational and institutional capturing the scale effect discussed above, (iii) population density to proxy for restructuring of the remaining three government-owned banks. The smallest the easier provision and delivery of financial services in more densely populated of the four state banks–Bank of Alexandria–was restructured and sold to Bank countries, and (iv) the age dependency ratio to control for the demographic Sanpaolo, though plans to divest from a second government-owned bank had structure and its impact on savings and thus demand for financial services.1 to be aborted due to the Global Financial Crisis of 2007/8, reduced demand for banks in developing countries, and political opposition. In addition, the Figure 2.3 shows that the level of saving mobilization by the banking government divested their shares in several joint-venture banks. The banking system has been higher than predicted by country characteristics, although sector experienced a consolidation process driven by higher minimum capital the gap has been recently closing. We also note that the level of Bank Deposits requirements and by the exit of several weak banks, with the number of banks to GDP has actually decreased over the past years. Figure 2.4 shows that the 42 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 43 actual value of Private Credit to GDP has also been above the predicted value Egypt’s financial system is bank-based, with banks constituting over for many years, but has moved below it for 2009, both due to the drop in the 95 percent of the financial system’s assets. Even though there are many actual level of private sector lending as to the increase in the expected value. other institutions, including finance and leasing companies, they are often The progress made in financial sector reform has thus not been reflected yet in linked to banks through ownership. This can also be seen in the fact that aggregate financial sector indicators. While savings mobilization as captured by banks are allowed to own insurance companies, leasing companies and other Bank Deposits to GDP has stagnated, private sector lending actually declined. subsidiaries in the financial sector. This can be explained by the fact that banks started building provisions and Intermediation efficiency. While Egypt’s financial system is relatively tightening their procedures and controls in response to regulatory pressures. large and of the predicted size for its level of income, the loan-deposit ratio is Notwithstanding this caveat and while quantity is certainly not be equated very low at 52.7 percent (as of 2009), evidence of low intermediation efficiency, with quality, the lack of a medium-term increase in Private Credit to GDP in spite of high savings mobilization capacity of the banking system. The following the financial sector reform programs is somewhat disappointing and explanations are numerous. Government’s financing needs crowd out credit matches the development of demand-side indicators, as we will discuss below. to the private sector, reflecting the (perceived) lower risk of government Figure 2.3: Actual and Predicted Level of Bank Deposits-to-GDP securities and the fact that they count towards the 20 percent liquidity 0.90 requirements. In the process of post-revolution political changes, even higher 0.80 financing needs from the government can be expected, which will lead to 0.80 further pressure on banks in terms of providing credit to the private sector. 0.79 0.78 0.78 0.70 0.76 Finally, and as we will discuss in more depth below, credit is concentrated 0.75 0.75 0.71 0.60 among a few borrowers, with the large majority of the enterprise population 0.66 0.61 0.50 being left out. 0.40 Market structure. The Egyptian banking system shows a 0.30 concentration ratio of 46 percent for the largest three banks and 56 percent 0.20 for the largest five banks, which is comparable to other middle-income countries of Egypt’s size. As result of the privatization process, the share 0.10 of state-owned banks has fallen to below 50 percent. However, in terms of 0.00 physical presence and outreach, the three state-owned banks still constitute 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 more than half of the system. While the system–consistent with its scale - Observed does not seem to have an excessive degree of market concentration, the Expected Median market structure says relatively little about competitiveness. While there is a lack of data to gauge the degree of contestability and competition within Figure 2.4: Actual and Predicted Level of Private Credit-to-GDP the banking sector, several indicators point to a lack thereof. First, no new 0.60 bank has been licensed over the past few years and there is an implicit moratorium by CBE on new banks; this reduces the contestability of the 0.50 market and pressure on incumbent banks. Second, the continuing large 0.53 0.52 0.52 0.51 0.50 0.50 share of government-owned banks and the absence of market discipline and 0.47 0.40 0.44 lack of exit of failing banks, a topic we will come back to below. There is 0.41 0.38 0.30 also little competition from outside the banking system, consistent with the bank-based nature of the Egyptian financial system. Microfinance 0.20 institutions are restricted by the lack of a proper regulatory framework and the prohibition to take deposits. Lack of competition also characterizes 0.10 financial markets; for example, participation in government bond auctions is limited to a number of PDs with direct access. On the other hand, recent 0.00 steps are likely to have helped move the Egyptian system towards more 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 competition, including the introduction of I-Score, but much more remains Observed to be done, as we will discuss below. Expected Median Source: CBE. 44 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 45 Figure 2.5: Sectoral Lending Share of Egypt’s banking sector (2009) Figure 2.6: Maturity Structure of Egyptian Banks (2007–2009) 50 45 40 Agriculture 35 Manufacturing 30 Share of Trade and commerce 25 deposits over one Other services 20 year State-owned enterprises 15 Share of 10 Government authorities loans over 5 one year Households 0 2007 2008 2009 Source: CBE. Source: CBE. Outreach. There is very limited physical outreach of the banking Sectoral distribution of lending. As of 2009, bank loans to SOEs sector. Egypt has a branch penetration of 5.6 branches per 100,000 people, constituted 16 percent, up from 15 percent in 2007 and 14 percent in compared to an average of 13.8 for the MNA region. This also compares 2008. Lending to households has grown to over 20 percent, though most of unfavorably with comparator countries, such as Morocco, with 11.6 or South this has been for consumer lending, with only a small share for mortgage Africa with 8 branches per 100,000 people. On the other hand, not included in lending, which is contrary to most developed countries in Europe, where these numbers is Egypt Post, which provides basic financial services to over often over 50 percent is for mortgage lending. Among private sector firms, 17 million clients through 3,700 offices across the country. the manufacturing sector receives the largest share, with overall 36 Looking beyond banking. As discussed earlier, the Egyptian percent, while trade, commerce, and other services receive 13 percent and financial system is diversified with many different institutional segments, 24 percent, respectively. Given that small enterprises are over-represented most of which, however, are not achieving their potential to the maximum in the services sector, including in trade and commerce, this is a first with respect to financial system users. While significant progress has been indication that small enterprises have limited access to credit. Estimates made in strengthening this important segment of the financial system, by CBE indicate that overall, less than one percent of private sector credit the NBFI segment continues to play a minor role when one considers the goes to small enterprises. possibilities offered by the scale and development of Egypt’s financial system. Maturity structure. There has been an increase in the share of Take the example of microfinance in Egypt, which has remained limited in deposits and loans over one year in the past few years, though the ratios size, with only a small portion of the potential market being served. There of short to medium- and long-term assets and liabilities are still relatively were only about 1.3 million active microfinance borrowing clients as of end- low, when compared with other countries. In Egypt, only 47 percent of loans 2008 and market participants estimate that the outreach of the microfinance are for more than one year as are 27 percent of deposits. This compares industry in Egypt covers only 25 percent of the potential borrowers among to Morocco’s share of loans over one year of 68.3 percent and 32.1 percent microenterprises and less than 10 percent of the overall potential borrower share of deposits over one year. South Africa’s share of medium- to long- population. In addition to several banks having dedicated microfinance term loans is 55 percent, although its share of deposits over one year is operations and two service companies working on behalf of banks, only lower than Egypt’s, with only 16.5 percent.Access to long-term finance is NGOs can be active in the microfinance area, as the current legislation does limited for both households and enterprises. Mortgage finance constitutes not foresee any regulated corporate entity providing such services. This also less than one percent of GDP (compared to 14 percent in Morocco), with implies that the NGOs rely completely on donor funding or development bank fewer than 75,000 customers. Deficiencies in the institutional framework funding, through the Social Fund for Development (SFD) or government (no centralized property registry) as well as regulatory restrictions prevent funding to SFD. Yet, the new micro finance law does regulate MFIs and the emergence of a thriving mortgage market, as discussed in more depth creates a committee to oversee the NGO’s with participation of both EFSA in other parts of this report. and CBE which still remain under the auspicious of ministry of solidarity. 46 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 47 As in the banking sector, there is also a geographic disparity in complying with enhanced disclosure requirements, limited resources to pay microfinance penetration. The estimated penetration rates for microfinance, listing fees, and the lack of understanding of the benefits of listing and of the as proxied by the number of microfinance clients as a proportion of the need to pay listing fees. estimated microfinance market, are significantly higher in the Urban Limited enterprise access to credit. Up until now, we have used Governorates (14.7 percent), and in particular in Cairo, than in the Lower supply-side data to gauge the depth and efficiency of Egypt’s financial system. Egypt Governorates (3.5 percent). User data provides a complementary and mostly consistent picture, but also Little financing has been made available for enterprises through the allows us additional insights into demand-side constraints. The Enterprise primary capital market. Feyen (2010) reports that more than 50 percent of Surveys–undertaken in over 100 mostly developing countries with a consistent listed firms have a share of freely trading shares in total shares (“free float”) of survey instrument - give important insights into the access to and use of less than 15 percent, and only 5 percent have free floats exceeding 70 percent. financial services by enterprises of different sizes, legal forms and ownership This also explains why the boom in listings and market capitalization was not structures. As discussed above, providing credit to enterprises with the most accompanied by a similar increase in liquidity; the turnover ratio, reaching promising investment projects is a critical function of the financial system 47 percent in 2007, is similar to the ratios in other middle-income countries, and ultimately the channel through which it fosters economic growth. In the while market capitalization to GDP is well above the average for middle- following, we will use data from the 2008 Enterprise Survey, unless noted income countries. More recently, in 2008, in a move to show preference for otherwise. We compare data for Egypt with both data from countries of the quality over quantity, the exchange changed its listing rules. The changes region (North Africa and Middle East) and data from several peer countries were aimed at strengthening governance and improving disclosure among outside the region, specifically Kenya, South Africa and Turkey. listed companies to enhance market liquidity. This reduced the number of listed companies to 218, down from 550. Trading statistics significantly Figure 2.7: Enterprise Use of Bank Credit across Countries – Percentage improved after these changes were implemented. of Firms that have Access to Banks’ Credit 70 One of the reasons for limited progress in developing capital markets is the absence of a meaningful domestic institutional investor base, which 60 brings us to contractual savings institutions. The insurance sector is still dominated by one large state-owned enterprise, though foreign companies 50 have gained market share. State-owned companies continue to dominate 40 the non-life market, which has made limited progress over the past decade. Strong growth in the life insurance business is related mainly to the 30 strong growth among foreign-owned insurers. Investments of insurance companies and private pension funds are concentrated in government debt 20 and bank deposits. Private pension funds show risk aversion, investing 10 mostly in government bonds and bank deposits, although regulations allow for up to 20 percent investment in equity and up to 20 percent investment 0 in corporate bonds. In the case of private pension funds, this can be explained by the fact that they are mostly managed in-house rather than 09 10 08 09 07 07 06 07 07 07 09 08 a en pt ria bia a an ria co a n y ric ke by ny no by professional fund managers, which partly explains their risk-averse y oc ra m Sy rd ge Af Eg r Li Ke ba iA Tu Ye Jo or uth Al ud Le investment strategies. M So Sa Source: Beck. Trading on Nilex, the second-tier board of the stock exchange is mostly by individual investors. The size of the available investments and trades might Figures 2.7 and 2.8 give a first insight into the access to and use of not be sufficiently attractive for institutional investors, such as insurance credit by Egyptian enterprises, comparing it to other countries. We find that companies and private pension funds or their risk aversion might be too high, a very low portion of enterprises (13.3 percent) reports using bank credit, as already discussed above. It seems that there is also a segment of firms higher only than Libya and Yemen, with the former being a resource-based that are considered too big for Nilex, but for which the listing requirements economy and thus expected to have a low level of enterprise access to credit of EGX are too burdensome, such as enterprises with equity between LE 70 (Beck, 2011) and the latter being a country with significantly lower GDP million and LE 200 million. So far, companies have not been keen to list on per capita. All other comparator countries, including several resource-based Nilex mostly for demand-side reasons, including the fear of losing control by economies in the region have significantly higher shares of enterprises that 48 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 49 use banking credit services. On the other hand, relatively few enterprises has a much lower share of enterprises that use credit than predicted by the report financing as a major obstacle to their operation and growth (Figure cross-country comparison. Specifically, corresponding to its level of Bank 2.8), including compared to several economies that show a much higher share Credit to GDP, more than twice as many enterprises should have access to of enterprises with bank credit. bank credit, as for example in Cape Verde, which has a similar level of Bank Credit to GDP (42.5 percent). The reason for Egypt being such a big outlier Figure 2.8: Enterprises’ Financing Obstacles across Countries – Firms lies in the banking sector focusing historically on mostly corporate lending, Identifying Access to Finance as a “Major” or “Very Severe” Obstacle based on names or connections, with the large majority of enterprises being 70 excluded from the formal banking sector due to their own lack of formalized 60 stance thus lack of formal documentation and financial statement. This also puts in perspective the high value of Private Credit to GDP documented above 50 and might explain why its growth effect is lower in Egypt than elsewhere 40 (Figure 2.10). 30 Figure 2.10: Use of Bank Credit across Different Enterprise Types in Egypt – Share of Firms with Bank Credit 20 30 10 25 0 20 07 07 09 09 09 08 07 03 06 07 8 10 07 t0 15 a ria n a ria y a an an bia en co yp ric ke ny by no oc ra Sy ge m rd m Af Eg r Ke Li ba iA Tu O Ye Jo or Al uth ud Le M So Sa Source: Beck. 10 Figure 2.9: Financial Depth versus Enterprise Use of Bank Credit 5 80.00 0 ) ) 0) ) d d ld ld O re =5 50 51 ne ne Percentage of firms with loan O O ar Mo 15 ld 6- =1 (< w w rs rs 1- 60.00 l( O O Ye Or (> ro a a (5 s al Ye Ye ic e ic e Sm 25 at m bl M rg 9 4 iv iu Pu 0- -2 La Pr ed 10 M Source: Egypt ICA. 40.00 The use of bank credit varies significantly across firms of different size, ownership and age (Figure 2.10). Large companies (more than 150 employees) 20.00 are more than twice as likely to use bank credit as medium-sized enterprises Egypt, Arab Rep. and more than three times as likely as small firms, with none of the surveyed micro/informal firms reporting to use bank credit. Publicly owned enterprises 0.00 are significantly more likely to use bank credit, while we see a hump-shaped 0.00 0.50 1.00 1.50 relationship between enterprise age and use of bank credit; the “mid-aged” Bank Credit to GDP Other firms (10 to 24 years of age) are more likely to use bank credit than young or EGY older firms. Fitted values Self-reported financing constraints also vary significantly across firms Figure 2.9 shows a positive, though non-linear relationship between of different size and ownership, though not systematically with age. There is the level of Bank Credit to GDP and the share of enterprises that use credit, a clear and significant negative correlation between the size of firms and the though there is significant noise in this relationship. Not surprisingly, Egypt likelihood of reporting access to finance as a major obstacle to the operation 50 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 51 and growth of the enterprise. Similarly, privately owned enterprises are larger firms. While the only reason that publicly owned firms do not have a almost three times as likely to report access to financing as a major obstacle loan is that they did not apply, this holds for less than 95 percent of privately as publicly owned firms. owned enterprises. As enterprises get older, they are less likely to not have a loan because they have not applied for one. It is important to stress, however, Figure 2.11: Access to Credit over Time in Egypt - Percentage of Firms that the differences across different firm types are smaller than the graph Having Access to Banks Credit in Egypt might suggest; across all firm types, more than 90 percent of enterprises 25 do not have a loan because they have not applied for one and less than five percent because they were rejected. 20 Given these limited differences, it is actually more interesting to explore why firms did not apply for a loan in the first place. Figure 2.12 and 15 Table 2.1 state the reasons of why Egyptian firms do not apply for credit, the average across developing countries, and several peer countries. Compared 10 to the average across developing countries and in the region, a smaller share of Egyptian firms states the lack of demand as reason for not applying, a difference even larger when comparing with South Africa and Turkey, with 5 Kenya being an outlier in the comparator group. 0 Table 2.1: Reasons For Not Applying For A Loan or Line of Credit 2004 2006 2008 2011 (Egypt Average South (Egypt ICA) (Egypt ICA) (Egypt ICA) Rapid Assessment) developing Egypt Kenya Turkey Africa countries Figure 2.12: Reasons for not having a Loan in Egypt across Do not need loans 59.3 53.2 41.9 64.7 81.1 Different Firm Types Application procedures Reasons for Not Having a Loan (Egypt ICA 2008) for bank loans are too 8 9 11.5 9.8 2.4 100% burdensome 99% Collateral requirements of 7.1 4 15.4 3.2 0.8 bank loans are too strict 98% Approval of the application is 97% still pending Interest rates are too high 14.7 12.2 19.9 11.5 7.7 96% The last application was Did not think that it would 95% turned down 3.1 1.8 3.2 5.9 1.6 be approved 94% I did not apply Size of loan and maturity are 93% 2.2 2.9 1 1.2 insufficient 92% Did not want to deal in 15.6 91% interest rates ) 0) 0) ) ed d ld d s O re =5 51 ne Ol sO -5 15 ar o wn ld =1 Ye Or M (< Ow (6 rs 1- r cO (> o ea ea Other 6.9 4.2 5.2 3.8 5.3 (5 all icr te 9Y 4Y e Sm bli 25 ium M iva rg Pu 0- -2 La Pr ed 10 M Source: Egypt ICA. Source: Egypt ICA. The Enterprise Surveys also provide us insights into the reasons why A larger share of enterprises indicated that application procedures are firms do not use formal bank credit and allow us to distinguish between more burdensome than in the average developing country and the average demand and supply-side constraints. While 95 percent of all Egyptian firms across the MENA region, though the share is lower than in Kenya and South without bank credit did not apply for such, the share is even higher among Africa. Interest rates are seen as more of an impediment in Egypt than in the 52 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 53 average MENA country and in Turkey, though this percentage is lower than in the average developing country and in Kenya. One striking finding (which Box 2.2: Reform Experience from Transition Economies and Turkey cannot be compared across countries) is the high share of enterprises that have not applied for a loan as they do not feel comfortable with conventional, The reform process of the transition economies after 1990 provides some interesting interest-based banking. This segment of the enterprise population certainly lessons for financial reform. Financial sector reform was part of a larger structural transformation of countries from planned towards market-based economies. Most constitutes a possible clientele for Islamic Banking. transition countries suffered banking crises in the 1990s, due to cycles of borrowers’ Overall, it seems that there is a large share of enterprises that do not repayment problems, previously non-recognized non-performing assets in the access bank credit as they do not see a need for it, which points to other non- banking system that grew, and recapitalization of banks by the government that financial constraints for these firms, relating to lack of market possibilities were subsequently monetized and led to inflation. The escape from these cycles was or other constraints in the business environment. However, a large share of a hard-budget constraint on enterprises and banks alike, and greater macroeconomic stability. At the same time, the successful reformers privatized their banking enterprises is discouraged by supply-side constraints in the banking system, systems, mostly to West European banks, simultaneous with a privatization process which points to structural impediments. in the real sector. This broke long-standing relationships between banks and (formerly) SOEs and enabled the entry of new firms. Supporting this process were also wide-ranging institutional reforms, including in the contractual framework, and Financing Egypt Post-Revolution–New Opportunities and the establishments of credit registries. New Challenges As discussed above, Egypt has the potential to significantly deepen and Similarly, the experience of Turkey provides interesting insights for the reform broaden its financial system over the years to come. Such a deepening and process in Egypt. After the financial crisis of the early 2000s, Turkey adopted a broadening might not necessarily become obvious from improved aggregate more stable macroeconomic framework, reduced the public sector significantly over 4 years, to less than 1 percent of GDP, borrowed substantially from the IMF and indicators, but a steeper relationship between these and economic growth and reduced other foreign debt, and aggressively addressed banking sector fragility, rates of poverty alleviation. This deepening and broadening will have to take the by taking over and either closing or restructuring and selling off banks and by form of a more inclusive financial system, with more enterprises and households substantially strengthening its regulatory and supervisory framework. Specifically, a having access to a broader variety of services and products. As already special resolution framework for banks was established and the banks were forced to discussed, Egypt has the necessary scale to sustain a diversified and competitive increase capital and move rapidly toward Basel II (IMF 2007 Article IV Consultation; financial system. The new political regime post-revolution offers (but does not IMF, Financial Sector Stability Assessment; and World Bank, Financial Sector guarantee) the chance to improve the governance and provide impetus for a more Assessment). There was a rapid decrease in the market share of government- owned banks (three large commercial banks effectively remained state-owned) and transparent, competitive and ultimately more inclusive financial system. Box an increase in share of foreign-owned banks. Critically, there was a simultaneous 2.2 discusses reform experiences from other countries and lessons learned. This process of privatization in the real economy. Turkey’s recovery took place in an section discusses three main challenges going forward. First, expanding access internationally much more benign environment than currently, with low interest to a greater share of households and enterprises; second, lengthening financial rates and foreign banks looking to expand, before the 2008–2009 Global Financial contracts; and, third, safeguarding the financial system in a more volatile Crisis. However, Turkey’s reformed financial system proved resilient to the Global environment, especially if the financial system indeed succeeds in lengthening Financial Crisis and avoided a domestic, systemic financial crisis. Source: Laeven and Valencia. maturities and expanding access to financial services. Expanding Access to Financial Services A discussed above, access to financial services, both credit and non- To achieve both objectives, more competition is needed. As discussed credit services, is very limited among Egyptian enterprises. While hard above, the bank-based and segmented nature of the Egyptian financial system quantitative evidence is missing, the share of households with access to undermines competition, with negative repercussions for users. The lack of adequate financial services is very low. In this context, it is important to competition prevents the adoption of new technologies and methodologies to look beyond credit services to other services, including savings and payments reach out to previously unbanked clients, be it in the form of new products services.Ideally, the reform agenda in expanding access should move on two or new delivery channels. It is important to stress that competition does levels: expanding access to credit for small and medium-sized enterprises not necessarily have to come from within the banking system or even the (SMEs) and expanding access to basic transaction and savings services to a financial system. As the example of M-Pesa in Kenya has shown, innovation larger share of households. Both objectives are consistent with the Finance and competition can come from outside the financial system. Policy makers for All agenda, the first also with the Finance for Growth and the second with have an array of levers available to increase competition in the financial the Finance for Markets agenda. system, a topic to be discussed in more depth in the next section. 54 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 55 One area of increased attention over the coming years will be Islamic Lengthening Financial Contracts finance. The first African Islamic Bank was created in the 1960s in Egypt, The availability of long-term financial products is still limited, for but little has happened since then, for several socio-economic and political both enterprises and households. As discussed above, the Egyptian capital reasons. First, North African countries follow for the most part a less markets still do not play their role sufficiently well as a financing source conservative interpretation of the Shari’a, along with a large part of Muslim for corporations. The segment of institutional investors, including insurance Asia, compared with the Gulf countries. Second, banks’ customers in North companies and private pension funds, is still too small and does not play a Africa have for a long time preferred CB for their transparency and lower meaningful role in the capital markets, being too timid in their long-term costs. A final reason behind this shallow emergence could be found in the investment strategies, as discussed above. The lack of long-term financing political will to avoid any religious tensions or the risk of perception that possibilities for firms matches the dearth of funding possibilities for working CB in the system are unlawful if an Islamic Banking is authorized. Today, capital, described above. The lack of mortgage finance opportunities–analyzed Islamic finance in Egypt has a market share of around seven percent, both in in more depth in other parts, is a symptom of the lack of long-term savings and the form of Islamic Bankings and of Islamic branches or windows. The new credit possibilities for consumers in the formal financial system. Mortgage political regime might provide more possibilities for Shari’a-compliant finance finance is critical to allow for a more organized urbanization process. in the future. As discussed above, there seems to be demand for Shari’a- compliant bank finance among enterprises, although it is not obvious that To achieve better access to long-term finance, the development of the this is the primary constraint for accessing bank credit. At the same time, non-bank segment of the financial system, especially of capital markets, is more resources flowing into Islamic finance, especially from Gulf countries, critical. Developing capital markets, including derivative markets would are looking for a home in Shari’a-compliant institutions. also increase the ability of banks and other financial institutions to better manage their maturity risks. Critical in this context is to develop the Another important area will be SME finance. While some innovation contractual savings industry further as well as the broader segment of has taken place, more is needed. Some of this innovation has taken place in institutional investors. In order to achieve this, governance reforms should state-owned banks, as the example of Banque Misr has shown, which has targeted the SME segment by allowing lending to SMEs to be conducted in a top the agenda for this segment of the financial system. The policy agenda in completely different way relative to corporate lending. This included hiring this area comprises two levels, which will be outlined in more depth below. young graduates as loan officers without the preconceptions of experienced On the one hand, there is the agenda of long-term institution building, while loan officers in terms of risk assessment. More broad-based innovation, with maintaining and improving overall macroeconomic stability. On the other a stronger focus on SME finance, is needed, in both publicly and privately hand, there are more short- to medium-term policy solutions, including the owned financial institutions, supported by the necessary regulatory reforms. development of risk mitigation tools, such as guarantee schemes and policies Moreover, Banque du Caire is putting more emphasis in his strategic direction to develop capital markets further, such as started with Nilex. Some of these on micro finance and National Bank of Egypt is focused on SMEs. policies are discussed in more depth in other parts of this report. While the focus in the access debate has been on credit services, broadening Safeguarding the Financial System access to payment and deposit services is as important. As discussed above, the The on-going economic and political uncertainty poses significant risks physical penetration of the banking system is limited and anecdotal evidence for the financial system. The regulatory authorities have played a positive suggests limited access of households to formal financial services. Recent role in securing the stability of the financial system. Going forward, this will experiences from other countries, including Brazil, Kenya, the Philippines and be even more important. While the financial system has proved to be resilient South Africa, show the promise of new delivery channels for financial services, during the global financial crisis and also to the political turmoil so far. If the such as mobile phone based payment services and agency agreements. In the promises of more private sector lending, both to enterprises and households, context of exploring new delivery channels, the use of the Post Office’s extensive take place, many banks might need more capital, as private sector lending branch network for financial service provision by other publicly- or privately-owned requires more capital charges than supposedly safer government lending. financial institutions should be explored. Expanding access to financial services will also need a stronger focus on the demand side, including financial literacy and Financial stability relies on a balance of supervisory and market business development services. Efforts on this regard include the formation of a discipline. Currently, however, the emphasis in Egypt is excessively on financial literacy committee at the EBI to draft a national strategy for illiteracy supervisory discipline. The emphasis on supervisory discipline goes hand- with member of the board from CBE, EFSA, ministry of Education, and banks. in-hand with an implicit government guarantee for all banks, not just The lack of proper financial statements constitutes a barrier for many SMEs to government-owned ones. Effectively, no bank has been allowed to fail. This, access formal bank credit. It would be helpful to develop and propagate the use of however, undermines market discipline as well as competition. Going forward, simplified financial statement rules for SMEs. the improved supervisory discipline should therefore be complemented and 56 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 57 balanced with more emphasis on market discipline. As discussed above, or policy holders, but their management is influenced by the systemic risk financial sector governance reforms also play a critical role in this context. environment. Two factors are particularly important in explaining the Critical in the context of more market discipline is the introduction of an differences in idiosyncratic risk: agency problems, stemming from information incentive-compatible resolution framework for failing banks. asymmetries between debtors and creditors, and limits to the possibility of diversifying risks not related to agency problems. Priority Policy Areas and Classification The financial depth frontier is determined by state variables that are Having discussed the three priority areas of action, specific policy either exogenous to the country–such as country size and state of technology, areas that can help achieve the three goals will now be discussed. To classify exogenous to the financial sector policy makers–socio-political stability, the policies to achieve progress along these three dimensions, the concept economic structure–or policy areas that are not subject to short-term changes– of a financial depth frontier is introduced (Beck and de la Torre, 2007; IMF including contractual and information frameworks, market development, 2012). This frontier is the point of the maximum possible commercially viable etc. These State variables provide not only a floor for the costs of financial outreach or depth of the formal financial system given the technology and service provision but also the environment in which financial institutions the macroeconomic and institutional framework (Beck and de la Torre 2007). can manage their risks. Better macroeconomic management allows better The concept of the financial depth frontier builds on the two main risk management, better developed contractual and information institutions barriers that financial institutions and markets face in deepening and reduce the costs of screening and contract enforcement and again allow broadening: (1) transaction costs and the resulting scale economies of financial better risk management. Technology can reduce the costs of financial service services at the level of the user, the institution, and the market and (2) provision. Using the concept of State variables allows us to define the financial systemic and idiosyncratic risks. Fixed transaction costs in financial service depth frontier as a rationed equilibrium, that is, the maximum sustainable provision result in decreasing unit costs as the number or size of transactions depth and breadth of a financial system. This frontier is different for savings increases. These fixed costs exist at the level of the transaction, client, and payment services, in which the transaction costs are the decisive market institution, and even financial system. Processing an individual payment or friction, and credit and insurance services, in which the risk dimension is savings transaction entails costs that are, at least in part, independent of an additional important friction. However, the frontier is also determined the value of the transaction. Maintaining an account for an individual client by demand-side constraints, including voluntary exclusion or exclusion for also implies costs that are largely independent of the number and size of the religious reasons. transactions the client makes. At the level of a financial institution, fixed costs The concept of the financial depth frontier allows us to categorize policies span a wide range—from the brick-and-mortar branch network to computer according to whether they can move the frontier outwards, move the financial systems, legal and accounting services, and security arrangements—and system towards the frontier or prevent an unsustainable equilibrium beyond the are independent of the number of clients served. Fixed costs also arise at frontier to emerge. Following Beck and de la Torre (2007), these policies can also the level of the financial system, including regulatory costs and the costs of be classified as market-developing (moving out the frontier by developing new payment, clearing, and settlement infrastructure, which are, up to a point, markets), market-enabling (moving towards the frontier by exploiting existing independent of the number of institutions regulated or participating in opportunities) and market-harnessing (avoiding overshooting) policies. It also the payment system. The resulting economies of scale at all levels make it gives a timeline for different policies to take effect. While policies to move the unprofitable to stay in the business of financial service provision unless the frontier outwards will take some time to take effect, policies to move the financial associated scale economies are captured in some form.2 systems towards the frontier are of a more short-term nature. While a move beyond In addition to costs, the expansion in the supply of financial services, the frontier towards an unsustainable equilibrium seemed an unlikely outcome especially credit and insurance services, is constrained by risks particularly only a few years ago, more competition, a more open regulatory environment and the risk of default. The risks can be either contract specific or systemic. possibly political pressure will make this a more possible outcome. Finally, the Systemic risk can be defined as risk that is non-diversifiable within a given classification of different policies also allows us to distinguish between necessary economy and stems from high macroeconomic uncertainty (reflected in high policies (pushing out the frontier) and sufficient policies (moving towards the inflation and exchange rate volatility), weaknesses in the contractual and frontier).While a broader set of data would be needed to locate the frontier in the informational environment, or geographical limitations. As systemic risk case of Egypt, the previous discussion has shown that Egypt’s financial system increases, it enlarges the set of borrowers and projects that find the cost of is far from its frontier of possibilities, while there is also significant room for the credit unaffordable and are thus priced out of the credit market. Similarly, frontier to move out.3 this makes insurance policies unaffordable for larger segments of the In the following paragraphs, five areas will be discussed. First, population. Idiosyncratic risks are specific to individual borrowers, projects macroeconomic stability is a pre-condition for financial deepening, to sustain 58 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 59 a high frontier and push it further out. Second, institution building in the market; currently, mortgages are registered with a local notary public, which areas of contractual and information framework and is critical to push out the does not allow for checking claims on a national basis. There is no legal and frontier. To benefit from a wider frontier, however a redefinition of the role institutional framework for movable collateral. Further, the insolvency regime of the government is necessary, beyond the substantial reforms of the past is ineffective, focusing exclusively on liquidation rather than allowing for years. Similarly, the lack of competition and regulatory constraints prevent restructuring of viable enterprises, which undermines its effective use. Many of the financial system from reaping the benefits offered by new technologies. these reform needs are discussed in other parts of this report. Finally, a new regulatory approach that gives more space to market-based Reforms of the contractual and information frameworks will help push financial innovation is advocated, while at the same time helping to foster the frontier out, they will enable the creation of new or the deepening of greater market discipline. It is important to stress that the further deepening existing market segments–such as mortgage finance, derivative markets and broadening of the financial system can only take place in the context of etc.–and thus provide possibilities to deepen the market. As in the case of a stable, but open political environment. A stable political environment will macroeconomic stability, however, these measures are necessary but not also be critical in terms of attracting urgently needed foreign capital flows, sufficient conditions for deepening and broadening the financial system. This both directly but also through the banking system. will require additional policies that will be discussed next. Macro and Socio-Economic Stability Redefining the Role Of Government A sound and effective financial system depends critically on the The Financial Sector Reform Program has significantly contributed to macroeconomic environment in which it operates, as the current Euro crisis a redefinition of government’s role in the financial system by substantially has shown again. Maintaining fiscal discipline will be crucial in the coming reducing the ownership share of government in banking. It is important months and years, as public pressure on fiscal policy will increase, partly due however, that this progress be not reversed under current political pressure to the democratization of the political process. However, it will be more than in the political transition process. It is important to understand that a ever critical to reduce crowding out effects on the banking systems and in private-sector led financial system is critical for its positive impact on bond markets and thus give sufficient space for private sector lending. economic growth, notwithstanding an important role for government, a topic It is important, however, to understand that a stable macro- to be discussed shortly. Such a private-sector led financial system, however, environment–i.e., a low and stable inflation rate, a sustainable fiscal position has to function within a competitive environment and within a regulatory and stable exchange rate - is a necessary, though far from sufficient condition framework providing the right incentives for sound risk decisions. This has for further financial deepening and broadening. Macroeconomic stability critical repercussion for corporate governance and the relationship between determines the location of the financial depth frontier; however, it does not market participants (including banks) and supervisory authorities. The determine the location of the financial system with respect to the frontier. failure over the past years has not been so much in shifting towards private Egypt had achieved a certain degree of macro- and socio-economic stability ownership but falling short in the governance agenda, lack of competition over the past decade or so, without having been able to reap the benefits in and failure to properly redefine the relationship between market participants terms of a deeper and more inclusive financial system. and authorities. Institution Building Beyond the significant reforms under the Financial Sector Reform Program over the past years, there is thus a need to redefine the role of Building the institutional framework for financial institutions and government in financial markets along two dimensions. First, a further markets to function effectively is the quintessential market-developing policy reduction in direct government involvement on the retail level through area. Such reforms address deficiencies in the State variables that keep the government-owned commercial and development banks, and, second, a frontier too low. On the one hand, important reforms have been implemented redefinition of the relationship between market participants and supervisory over the past years, which earned Egypt the title “Doing Business Reformer authorities. of the Year” on several occasions. Most notably, the establishment of I-Score, the privately owned and managed credit bureau, constitutes an enormous Consider first, direct government involvement in the financial system. improvement in the informational framework as already discussed above. While the long-term objective should be that of a privately led financial system, Anecdotal evidence suggests that the introduction of economic courts has the short- to medium-term objectives should be to minimize government also been helpful. interference in the commercial operations of government-owned financial Nevertheless, further reforms, are urgently needed as a basis for enabling institutions. This implies pushing forward with the restructuring of the three more long-term finance and expanding the universe of bankable entrepreneurs. remaining commercial banks in state ownership as well as redefining the role Specifically, the lack of a centralized property register holds back the mortgage of the development banks and restructuring these institutions accordingly. 60 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 61 There is a need to strengthen governance in three major government-owned Exist of French banks in 2013) the exit of weak banks is subject to other banks even further to isolate them from any government influence, which resolution techniques such as mergers acquisitions with the purpose to will most likely increase in the coming years. Potential issues are raised by safeguard the clients’ deposits. This regulatory and supervisory approach is the chairing of the general assemblies of state-owned banks by the Governor best understood on the background of several decades of financial repressions of the CBE. Beyond the government-owned banks, this would also imply with heavy-handed regulatory involvement. The further rebalancing of eliminating the conflicts of interest in the CBE Board and Bank Supervision supervisory and market discipline is thus as much an issue of attitude as Department. The chairmen of two active commercial banks have been it is an issue of specific regulations. Redefining the relationship between appointed to the CBE Board as representatives of the Ministry of Finance market participants and supervisory authorities has benefits both in terms and Ministry of Planning and Foreign Trade, while CBE acts at the same of market-enabling and market-harnessing policies. It can help foster the time as regulator of these institutions. In addition, the access of these board necessary innovation (partly through more competition as discussed below) members to confidential information on other banks creates a potential and help increase financial stability by strengthening market discipline and conflict of interest. In more general terms, a level playing field between banks fostering more adequate risk decisions. of different ownership and of different sizes has to be ensured. While a reduced role of the government in retail provision of financial Given popular opposition, alternatives to the privatization of services is advocated, there are other ways that the public sector can help government-owned banks should be explored, including management move the financial system towards the frontier beyond macroeconomic contracts. Examples from Sub-Saharan Africa — such as the National stability and institution building. One of these market-enabling policies is Microfinance Bank in Tanzania–have shown that such an approach can be to provide risk mitigation tools, such as credit guarantees, which can help useful. Under a management contract, a private firm assumes the overall overcome market frictions, including the lack of collateral by many SMEs and responsibility for the operation and maintenance of a service delivery system mitigate liquidity and maturity risks. As so often, the devil is in the detail and retains the freedom to make day-to-day management decisions. In the of pricing, funding, and institutional structure. The important assessment context of further restructuring of government-owned financial institutions, it criteria for credit guarantee schemes are additionality and sustainability; is critical to come up with a clear ownership policy that defines objectives and how credit-worthy borrowers, who never accessed a loan, could be included role of government authorities in government-owned financial institutions. because of a given or potential scheme, not only requires an assessment of This ownership policy should be published and should not be subject to the additionality effect itself, but also an assessment of the credit-worthiness frequent change. An interesting option, also applied successfully in several of those additional borrowers. The other important criterion is financial sustainability. The design of the scheme can be critical for reaching these Latin American countries was to move away from offering retail services, two goals. through specialized DFIs, towards a wholesale model, such as through the Social Fund for Development. In more general terms, it is important that the Competition and Innovation government undertake a holistic review of the sector and, for each institution Redefining government’s role is still on the more general policy level, and program, explore and define (i) mandate, (ii) different options, and (iii) but is not an objective per se. Rather, defining the relative roles of public funding of subsidies. If the government considers subsidies in the financial and private sectors ultimately has the goal of ensuring competitive and sector necessary, then such programs should be made available for both sustainable financial markets. Competition is critical for setting incentives private and state-owned financial institutions to the same extent, to thus for financial institutions to maximize the exploitation of the possibilities create a level playing field. created by a conductive macroeconomic environment and technology and As important as addressing the governance issues in public-sector thus push the financial system towards the frontier. However, this entails banks and leveling the playing field between public and private financial a sophisticated approach that has to balance the need for innovation and institutions is to redefine the relationship between private market participants the need to reduce the risks of fragility. Competition has been shown to be and supervisory authorities. This would imply adjusting the regulatory critical for deepening and broadening the financial system, but can also framework for privately owned banks, with the goal of balancing supervisory have negative repercussions for stability if coupled with a weak regulatory and market discipline, where the emphasis is currently completely on the framework. In this context, it is important to understand that market former. Specifically, the regulatory approach is currently one of guidance structure is not the same as competition; even concentrated banking systems of market participants. Two examples include the branch regulation policy can be highly competitive if there is a level playing field among several strong although it takes into account branches expansion in remote areas outside players, contestability achieved with the threat of entry, and competition greater Cairo and Alexandria and the lack of a bank resolution framework, from players outside of the sector. On the other hand, a dispersed banking yet it is evident that any bank wishing to exit the market is free to do so (ex. system of niche banks typically shows a low degree of competition. 62 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 63 There is an implicit de facto moratorium on new bank licenses as Regulatory Framework That Balances Stability And Access to Finance Concerns evidenced by the fact that since 2006 no new bank has obtained a license. The role of competition to push the financial system towards the Egypt seems to be lacking a clear policy concerning new bank entry, be frontier and the necessary changes in the role of government that this implies it domestic or foreign players. The background for this seems to be the has already been discussed. In the following final sub-section, the focus is consolidation process of recent years, which led to the exit of several weak specifically on regulatory policies that can help push the financial system banks and the emergence of overall larger–and better capitalized - banks. towards the frontier, while at the same time preventing it from moving beyond To ensure the necessary competitive pressure, opening the banking sector the frontier. Some of these policies will also have an impact on competition. for new players is critical. In addition to allowing new entry, there are other Looking at the specific affirmative regulatory policies that have the goal means to encourage competition between incumbent institutions and thus to move the financial system towards the frontier, the Egyptian authorities deepen and broaden the financial system. In terms of access to markets–and have introduced an exemption from reserve requirements for the amount as noted in other parts of this book–the playing field across banks is not level, that banks lend to SMEs. Rather than having exemptions or regulatory with only some banks being PDs for government banks, while others having “subsidies” for SME lending, it would be better to have a regulatory framework only indirect access. Using the franchise value and the network coverage that is flexible towards lending to different client groups. Regulations more of the Post Office for outreach purposes can increase significantly access to conducive to fostering SME lending would be to allow for more flexibility banking services, as the example of Brazil has shown. in terms of which asset classes can be used as collateral in terms of loan Fostering competition implies looking beyond the banking system. As provisioning rules. Similarly, relaxing the rule that all corporate borrowers noted in several previous instances, the non-bank component is extremely (including SMEs) have to have audited financial statements can help expand underdeveloped. One segment that can complement the banking system as the bankable share of enterprises. well as provide competition is the microfinance segment. Currently limited to Another important area for regulatory reform in the coming years will the NGO model, new legislation foresees them taking corporate form and being be on Shari’a-compliant finance. As discussed above, there is most likely more supervised by EFSA. However, they would still be limited to credit services. latent demand for Islamic financial products. It is important that the regulatory In the medium-term, it might be advisable to allow sound microfinance authorities keep an open mind about this. In this context, it might be important to institutions to start collecting deposits–a move that would imply supervision by introduce the necessary infrastructure for Islamic products, including a Shari’a- CBE rather than EFSA. Alternatively, one could think of a separate regulatory compliant discount window. However, it might also require careful risk-based form, such as micro-deposit taking institutions, such as in Uganda. supervisory monitoring. There are also areas where there is regulatory overreach, Innovation for the financial system can also come from outside the such as the branch requirements that seem rather burdensome, including the financial system, such as from telecom companies providing mobile payment requirement that banks need a certain capital to open a new branch and have services. It is important for regulators to focus on the specific financial services to submit a business plan. Similarly, a less restrictive approach in terms of offered or proposed, not the nature of the institution providing or aiming permitting new products can be conducive for the necessary financial innovation to provide the services. This view encourages the unbundling of financial to deepen and broaden Egypt’s financial system to the benefit of many users. services across banks and nonbank actors. As long as the risk of consumer Regulatory policies that allow for more innovation and focus less on abuse is adequately guarded against, different actors should be encouraged prohibition should be accompanied by a stronger focus on accountability and or at least not discouraged from providing narrowly defined services. This market discipline; this should include encouraging more banks to list on the could include deposit collection services by non-financial corporations, stock exchange, and to obtain a credit rating from international credit rating including supermarkets and others, working with banks in the form of agency agencies, as well as establishing an incentive-compatible bank resolution agreements, or payment services offered by telecomm companies. framework that allows for the failure of banks without disrupting the Competition can also be fostered by broadening the use of financial remaining financial system and the economy at large. Ongoing governance infrastructure. For example, it is important to encourage the use of credit reforms for commercial banks, including the forthcoming Corporate information by microfinance institutions, if necessary with a subsidy on Governance Code for the banking sector and including governance criteria in the costs. Another important policy tool to foster competition is through the supervision process are welcome developments in this context. transparency, by, for example, starting with publishing more information about banks. The decision by CBE to begin disclosing and making public on its website the consolidated banking sector financial statements and related Concluding Remarks indicators is a welcome first step. Other areas where more transparency and Financial deepening is pro-growth and pro-poverty reduction, as disclosure can help relate to account-related fees and conditions for customers. shown by a substantial amount of empirical evidence over the last 20 years. 64 Financial Development and Inclusive Growth Banks, Economic Growth and Opportunity 65 In mobilizing deposits, Egypt has done somewhat better than comparators. Endnotes However, its intermediation of deposits into credit to the private sector–a 1 For more detail, see Beck et al. (2008). key factor in allocating savings well and increasing growth and employment 2 See Beck and de la Torre (2007) for a more detailed discussion. has not been as good. Private sector credit has grown even more slowly than 3 Such data would include high-quality firm- and household-level survey data on the access to and use of financial services plus detailed data on geographic and contractual barriers to access the financial system. deposits in the last few years. This lack of financial intermediation reflects crowding out of banks’ credit to the private sector by government borrowing to finance its deficit and to replace the government debt that foreigners have sold off recently. This lack of intermediation limits credit to micro, small, medium and large private enterprises. The funding of enterprises is also limited by a capital market that is not particularly large (although it includes an exchange for small enterprises), and the lack of micro financial institutions. Egypt has done better in increasing the resiliency of the financial system; it avoided a systemic crisis that would have reduced GDP during the global financial crisis that began in 2008 and in the aftermath of the January 2011 revolution, so far. It also has done well recently in developing financial infrastructure, for example a credit information bureau (I-Score) that improves lending decisions, a safe and secure payments system that can handle low value transactions, payments cards that permit over 2 million government employees and retirees to receive payments through ATMs, and licensing of 2 mobile payments networks. As discussed, a number of actions would improve the functioning of the financial system, increasing its size, increasing its funding of the private sector and providing financial services—Finance for Growth, Finance for Markets, and Finance for All. These begin with greater macroeconomic financial stability to make more funds available for the private sector. Macroeconomic stability—low inflation and lower government deficits consistent with the growth of the financial sector and manageable inflows— macroeconomic stability is a necessary but not a sufficient condition for financial deepening, faster growth, and faster reduction in poverty. Other actions include continued attention to financial stability by the CBE, in particular a stronger early warning and prompt corrective action framework with a legal system for bank intervention and resolution. At the same time, actions could be taken to reduce regulations that limit access to financial services and competition, such as limits on ATMs and bank branching. Strengthening the PBDAC would take advantage of its large branch network to provide increased financial services and increased competition, particularly in the rural areas; consideration should also be given to enhancement of the capacity of the Egypt Post in these areas. Competition with banks and increased access could also be improved by a non-bank financial intermediary law that strengthens the role of micro-finance institutions, advancing the use of the licenses for mobile banking, and by improving credit information in I-Score to cover micro-borrowers. Finally, although Egypt has the longest experience of Islamic finance, there are still many obstacles facing Islamic finance. The most important is the lack of rules and regulations governing Islamic Banking up until now. 66 Financial Development and Inclusive Growth The Development of the Capital Markets 67 3. The Development of the Capital Markets Equity Markets National economic development is a critical objective of all governments. In countries with market-based economies, a well-functioning capital market is viewed as an essential component of a national economy. Capital markets are a tool to enable companies and entrepreneurs to raise investment capital to develop and expand businesses. They are a price discovery tool, to enable investors and companies to determine the market value of a company and its stock. The process of “going public” is one effective exit strategy that enables early investors to sell their interests for a profit to other investors. By providing an “exit strategy” vehicle, capital markets make early stage investing more attractive, and more available. Capital markets are also essential for retail and institutional investors that are interested in expanding and diversifying their investment portfolio and, in the process, obtaining a higher return on investment. Governments that have substantial ownership interests in the national economy can use capital markets to privatize these assets through an open, fair and transparent process, which can maximize the sales price and reduce the potential for corruption or cronyism. The equity market witnessed several phases since its reinvigoration in the early 1990s. The first phase was associated with the Economic Reform and Structural Adjustment Program implemented by the government with the assistance of the IMF in the early 1990s that led to the reinvigoration of the dormant equity markets via floating several SOEs through the stock market, ratifying the Capital Market Law 95 of 1992. The second phase was a 68 Financial Development and Inclusive Growth The Development of the Capital Markets 69 stagnation period that commenced with the South East-Asian financial crisis an increase from 30 percent to 107 percent of GDP. At the end of 2010, the in 1997 that was associated with the implementation of several measures, total market capitalization was LE 488 billion, approximately 40 percent of such as imposing a price band of ±5 percent for traded stocks, which were not Egyptian GDP. During its boom period, 2006–2008, the market cap of the EGX reversed until 2002. The third phase was associated with the implementation compared favorably to stock exchanges in other emerging market countries. of Phase I (2004–2008) of the Financial Sector Reform Program mentioned Following the global financial crisis of 2008, the EGX has not recovered as earlier. The equity markets reforms pertinent to Phase I, aimed at improving well as other emerging market exchanges. In 2010, its market cap to GDP the regulatory framework governing the equity market in Egypt in addition to ratio ranked sixth of the seven exchanges in this sample. activating the secondary market via partially floating SOEs, and introducing several measures, inter alia, margin trading, intra-day trading, establishing a Table 3.1: Stock Market Capitalization as a Percentage of GDP special trading market (listing schedule) for SMEs, activating the Settlement 2010 2011 2012 2013 Guarantee Fund (SGF) and establishing the Investor Protection Fund (IPF). Market Capitalization per end of year in billion EGP 488.2 293.6 375.6 426.8 The Revolution of 2011 has had a deleterious impact on Egypt’s economy, Source: EGX. and negatively affected the implementation of Phase II (2009 - 2012) of the Financial Sector Reform Program for the capital markets. Furthermore, While the total trading volume on the EGX has grown over the decade, the economic growth has declined. A significant decline in capital inflows has put value of shares traded has reflected rises and falls in the market. Total shares pressure on national currency reserves and the value of the Egyptian pound. traded grew from 5.3 billion shares in 2005 to a peak of 36.6 billion shares in The national credit rating has been downgraded, as has the credit rating of 2009. It dropped slightly to 33.4 billion shares in 2010. The value of this trading major Egyptian banks. Several highly publicized lawsuits have challenged volume also grew from LE 160.6 billion in 2005 to a peak of LE 529.6 billion in the legitimacy of the former government’s privatization program. The EGX 2008 when the market rise crested. The value of shares traded declined since this closed for eight weeks in 2011 and it has yet to fully recover. At this point peak, to LE 448.2 billion in 2009, and then to LE 321.4 billion in 2010. in time, it is uncertain whether Egypt will continue the initiatives of the As of 2010, there were 212 listed companies on EGX, a decline from past decade or pursue a different approach to economic growth. This section 435 in 2007 and 744 in 2005 (Table 3.2). The decline was part of the reform describes the capital markets of Egypt and the developmental efforts of the efforts of the EGX to enforce EGX listing standards, to delist dormant and past decade. Recommendations are included on how to use the foundation family held companies with negligible if no trading activity. The EGX has laid in the past decade to build a robust capital market in Egypt. pursued a program to encourage private companies to undertake an initial public offering (IPO) and list on the EGX. In 2010, there were three IPOs Overview of the Egyptian Equity Market (Table 3.3). In addition to IPOs, the EGX gained 16 new listings in 2010 The Egyptian Exchange (EGX). The Egyptian Exchange is the oldest totaling LE 1.9 billion and 6 new listings totaling LE 3.3 billion in 2009. Once stock exchange in the MENA region. The EGX was created by the consolidation again, Egypt lags other emerging markets in the number of IPOs. of the Cairo Stock Exchange (founded in 1903) and the Alexandria Stock Exchange (founded in 1883) by the Law 123 of 2008 amending the Capital Table 3.2: Number of Listed Companies Market Law 95 of 1992. The combined exchanges were the fifth largest in the 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 world in the 1940s. After a dormant period from 1961–1992, the exchanges Egypt, Arab Rep. 1,110 1,148 967 792 744 603 435 373 305 211 were revived as part of a national privatization program. Selected Peers The EGX has an ambiguous legal status. It is wholly owned by the Indonesia 316 331 333 331 335 344 383 396 398 420 Egyptian government and has an independent status but it is not a corporation. It is governed by Presidential Decree 191 of 2009 and subject to regulatory Philippines 232 235 234 233 235 238 242 244 246 251 oversight by EFSA. A Board of Directors (minimum five and maximum nine Saudi Arabia 76 68 70 73 77 86 111 127 127 146 members) governs the EGX. The Chairman and Vice Chairman of EGX are Thailand 385 398 421 464 504 518 475 476 535 541 appointed by the Prime Minister; the remaining members are selected by Turkey 310 288 284 296 302 314 319 284 315 337 member firms (brokerage firms, asset management firms, banks) and listed Vietnam - - 22 26 33 102 121 171 188 164 companies. In 2014 a presidential decree amended the EGX charter, adding to its board two independent directors. Source: World Bank FINSTAT database. Market capitalization in the EGX rose from LE 172 billion at the end The EGX is dominated by trading in a small number of equities, of 2003 to a peak of LE 768 billion in 2007 (Table 3.1). This represented the largest company, Orascom Construction Industries (OCI), before its 70 Financial Development and Inclusive Growth The Development of the Capital Markets 71 delisting used to represent over 12 percent of total market cap. The ten Table 3.4: Stock Market Turnover Ratios largest companies equal over 44 percent of total market cap and account for 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 almost 46 percent of total trading value. In 2010, the 30 largest companies Egypt, Arab Rep. 14.7 10.1 12.3 17.1 43.0 54.8 45.6 61.9 60.1 43.0 (EGX30) represented 53 percent of the total market capitalization and accounted for 68 percent of the total trading volume and 63 percent of the Selected Peers total value of shares traded. This level of market concentration in the largest Indonesia 38.8 49.2 34.9 43.1 54.2 44.3 64.4 71.3 83.3 48.1 companies is typical of stock exchanges in emerging markets. Ideally, the Philippines 9.3 7.7 8.4 14.0 20.1 20.7 34.1 22.2 26.0 22.6 level of concentration declines over time, as the market matures, new Saudi Arabia 31.7 48.2 137 204 232 288 162 138 119 60.5 companies are listed and listed companies grow in size. Since 2008, the Thailand 109 115 115 91.7 73.9 75.8 64.2 78.2 112 105 EGX has experienced an increase in concentration while all of the countries in the sample group, except Saudi Arabia, have experienced some level of Turkey 133 174 195 177 155 141 135 119 141.7 158.4 decline in market concentration. Vietnam - - - 31.2 24.8 22.4 87.9 28.8 43.2 141 Source: World Bank FINSTAT database. Table 3.3: Number of Initial Public Offerings 2005 2006 2007 2008 2009 2010 2011 2012 2013 NILEX trading was initially conducted through a one-hour daily auction. Member firms may submit customer bid and ask prices throughout Egypt 2 2 3 0 3 2 1 the trading session. Trades are executed at a closing price that enables Source: EGX and Bloomberg. the highest volume of shares to be traded. Trading on Nilex is mostly by The limited amount of free-float stock continues to hamper EGX individual investors. The small size of the companies and limited liquidity liquidity and development. It has been reported that more than 50 percent in the market, combined with the inherent risks of smaller companies likely of all listed companies have free floats of less than 15 percent, and only contributes to the lack of institutional investor interest. Currently, the 5 percent have free floats exceeding 70 percent. While there is no clearly NILEX trading is conducted through a continuous trading auction similar to defined “best practice” standard for the appropriate minimum free float, it the main market of EGX for four hours per day. is common for exchanges to require a free float of 25 percent or 30 percent EGX also provides facilities for OTC trading. There are nearly 1400 to ensure broad based share ownership and sufficient liquidity. The current companies that may be traded OTC. OTC trading occurs twice weekly in 90-minute listing, delisting and disclosure requirements require a minimum free float sessions for the “orders” market and 30 minutes for the “deals” market. The of 5 percent. Despite that, the EGX deems this figure insufficient for liquidity orders market is an open trading process with orders executed on a price and time development, the negative repercussions associated with increasing this ratio priority basis. The deals market is an execution publication process for negotiated in terms of the expected delisting remains a deterring factor for the EGX and bilateral transactions not exceeding LE 20 million. The value and volume of OTC ELSA’s board to increase this percentage. trading has declined sharply in recent years, with total share value dropping Egypt lags behind other emerging markets in the annual turnover from LE 115 billion in 2009 to LE 15 billion in 2013. Over the same period, share ratio of listed company stock. This reflects the low free float in most Egyptian volume traded declined from 8 billion to 1.7 billion shares. OTC trading accounted stocks. The turnover ratio of the EGX is the second lowest of the comparison for 9 percent of total market value traded in 2013, down from 26 percent in 2009. group and substantially below Turkey, Vietnam and Thailand. Only the It is worthy of mention that EGX is considered the registrar for all non-listed joint Philippines exchange is lower than Egypt (Table 3.4). The EGX is largely stock companies shares related transactions. This implies that all transactions a momentum-driven market with a high degree of price synchronicity and that incorporate transfer of ownership needs to be conducted through the EGX as a low level of effective price discovery. The World Bank Flagship Report on per the Capital Market Law. the MENA Region attributed this region-wide phenomenon to “the lack of a The EGX offers a narrow range of securities products. In addition to the diversified private institutional investor base combined with a large number listed company equities there are a small number of other securities traded, of uninformed small individual investors, a few high net worth (HNW) including 3 closed end funds and 1 Egyptian depository receipt (EDR) in Orascom individual investors, and large state investors all of which raise questions Development Holding (listed in Switzerland). The EGX does not provide trading about the quality of price discovery. While liquidity indicators seem in options, futures or other derivatives. While the EGX does not have any index- reasonable, there is also evidence that MENA equity markets have a high based products or exchange-traded funds (ETFs), these products are traded in degree of price synchronicity, suggesting that the quality of price discovery other markets. For example, several different index products based on the EGX30 may be deficient.” are traded in Milan, Luxembourg, Frankfurt and Stuttgart. In addition, Van Eck 72 Financial Development and Inclusive Growth The Development of the Capital Markets 73 Global launched in 2010 an ETF based on 25 companies that are either listed on provided with “overdraft” protection by brokers. Some brokers apparently the EGX or generating at least 50 percent of company revenues in Egypt. provide overdraft protection for an extended basis to favored clients. In The EGX is interested in developing additional investment products, addition to violating EFSA limits on margin lending, it may create significant such as exchange-traded funds (ETFs). Ministerial Decree 294 of 2007 created risks for other clients, as the cash used to purchase the securities may be a regulatory framework for ETFs and several brokerage firms are interested withdrawn from the omnibus account for client funds. in creating an ETF based on one of the many EGX market indices. Final Investors in the Equity Market approval by EFSA is required. Several proposed regulatory requirements pending EFSA’s approval have delayed final action, including a requirement Egypt’s capital market is dependent on retail investors. In 2013, retail that the ETF originator must guarantee a high correlation ratio (90 percent) investors accounted for 48 percent of the total value traded, a decline from between the ETF price and the underlying index, a requirement that there 63 percent in 2009. The dominant position of retail investors in the EGX has must be a minimum of two market makers who can originate ETF shares by been a long-term phenomenon. Retail investors represented over 51 percent creating pools of underlying stocks. of the market in 2000. The Egyptian regulatory structure includes a number of regulatory Table 3.5: Mutual Fund Assets (Percent of GDP) principles designed to reduce market volatility. Stocks traded on the EGX 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 are subject to daily price limits. 179 of the 212 listed companies on EGX are subject to a ±10 percent daily price limit. The remaining smallest- Egypt, Arab Rep. 1.0 - - 0.8 2.0 5.5 - - 4.6 - capitalization thinly traded stocks are subject to a ±5 percent daily price Selected Peers limit. Additionally, stocks traded with the ±10 percent price limit are subject Indonesia - - - 4.5 - - - - - - to a circuit break whereby trading halts for thirty minutes if the stock price Philippines 0.3 0.6 0.9 1.0 1.4 1.3 1.4 0.7 0.9 1.1 change exceeds ±5 percent. Licensed market intermediaries (stockbrokers) Saudi Arabia 7.3 6.9 6.7 6.4 11.6 6.3 7.3 4.2 6.4 5.8 are prohibited from engaging in proprietary trading, although affiliated Thailand 1.5 10.2 14.3 12.6 15.6 17.5 18.8 16.1 21.6 - entities under the same parent company, may engage in proprietary trading with the appropriate license from EFSA. Intra-day trading (buy and sell Turkey 2.0 2.7 4.4 4.4 4.5 2.9 3.1 2.5 3.1 2.8 in the same day) is permitted only for actively traded eligible stocks, and Vietnam - - - - - 0.2 - - - - during periods of general volatility, it has been prohibited. Brokers may Source: World Bank FINSTAT database. provide margin lending only for actively traded eligible stocks (this may be evaded in practice). While market volatility must always be a regulatory There were 91 mutual funds in Egypt as of February 2014, including concern in emerging markets, the consequences of adopting rules to limit 5 closed end funds. These funds are managed by 21 fund managers (44 volatility is often a reduction in market efficiency, effective price discovery fund managers are licensed). The mutual fund sector has grown steadily and market liquidity. Oftentimes these restrictions serve only to discourage over the past decade (Table 3.5). In 2001 there were 22 local mutual funds potential investors and exacerbate market volatility. In situations of general with total assets under management of LE 3.9 billion, managed by nine economic uncertainty, investors may prematurely leave a market for fear fund management firms. There were 68 funds in December 2009 and 49 in that regulatory interference in market trading will make it difficult to sell at December 2008. a later date. Mutual funds are not significant investors in equities. The largest mutual funds are money-market type funds that invest in short-term debt Equity Market Intermediaries or finance instruments. These funds control 90 percent of all mutual fund The market intermediary sector in Egypt is small and concentrated. As assets under management (AUM) in Egypt. This is a high allocation of assets of June 2013 (latest available data), 211 firms were members of the EGX and compared with other countries in the MENA region–for example Saudi Arabia licensed by EFSA. The 30 largest firms accounted for more than 80 percent of 73 percent, Morocco 31 percent and Kuwait 15 percent. Several offshore funds EGX traded value in 2010. Intermediaries may be wholly owned subsidiaries managed by Egyptian fund managers are significant investors in Egyptian of banks or other financial services companies, including foreign banks. capital markets. EFG-Hermes, the largest fund manager in Egypt (US$ 5.3 Brokers rely upon commission fees and margin loans for revenue. EFSA billion assets under management in 2009) operates two off-shore funds. permits margin lending for the purchase of liquid eligible stocks. Currently The current regulations for mutual funds state that the fund originator 83 EGX stocks are eligible collateral for margin loans. Clients interested in cannot issue new stocks/certificates more than fifty times the paid-in seed borrowing from brokers to purchase non-marginable stock are frequently capital, which in turn should not be less than LE 5 million. If the subscription 74 Financial Development and Inclusive Growth The Development of the Capital Markets 75 period expires without full coverage of the offered investment certificates, expertise. If successful, these companies should later become candidates for the fund may modify the amount being raised to be equal to the value of the a public offering and EGX listing, with the offering and listing providing an subscription provided it is not less than fifty percent of the total value of the exit strategy for the VC/PE investors. To date the impact of these firms on issued certificates. In such a case, all documentation of the Fund shall be the development of the capital market has been limited. In 2011, an OECD amended accordingly. If subscription applications to certificates exceed the study found that ambiguities in the regulatory framework had resulted in a number of offered investment certificates, the fund may adjust the amount number of entities registering as VC/PE to obtain beneficial tax treatment. to be invested to incorporate the surplus in applications. If this adjustment The same study concluded that the current EGX/OTC market failed to provide causes an increase above the amount mentioned above, appropriation will an efficient exit strategy. be made among subscribers each in proportion to his subscription. Fractions resulting from allocation process shall be rounded up in favor of small Recommendations for Equity Market Development subscribers. The Benefits of a Strong Equity Market The executive regulations of the Capital Market Law impose National economic development requires a system to effectively mobilize diversification requirements on fund investments. A fund may not invest more and allocate investment capital. Capital markets develop as one component than 10 percent of its assets in a single company, including related affiliates. of national economic development. An effective capital market strategy Also, a fund cannot own more than 15 percent of the total shares issued by cannot be built in isolation, or independently, from the other components of one company. A fund may not invest more than 20 percent of its assets in a modern market-based economy. While banks are an essential component of another mutual fund or own more than 5 percent of another mutual fund. this financial intermediation function, NBFIs working through sound capital Investments in other funds, except money market mutual funds (MMMF), markets provide an alternative to traditional banks. A vibrant and well- must be in unaffiliated funds. A fund may not invest more than 20 percent capitalized NBFIs can be an important complement to the banking sector. of its assets in an affiliated company or in the debt (including commercial It can provide short-term financing at a lower cost than banks. NBFIs can paper and short-term notes) of any one company. Funds are not permitted facilitate large-scale investment financing for longer terms than a bank and to engage in short selling or buying on margin. Funds may not trade with at fixed rates. Equity financing enables corporations to attract investment affiliates of the fund originator or fund manager. Finally, funds may not without the immediate obligation to pay interest on the investment. An invest in an entity where it would have unlimited liability. EFSA issued in efficient and active secondary equity market plays a pivotal role in the April 2014 specific regulations for Real Estate Investment Funds, mandating efficient asset allocation in any economy. It enables investors to share and a minimum of 70% of the assets to be revenue generating, a ceiling of 30% to diversify the risk in an efficient manner, improves the price discovery process be invested in one single project, in addition to defining the areas such funds for equities, and enables investors to rely upon this market for an exit from can invest in. their investments. Mutual funds are required to keep an unspecified amount of the fund assets liquid to satisfy anticipated redemptions. If the liquid funds are not Critical Pre-Conditions for Successful Development sufficient to meet redemption requests, a fund may borrow up to 10 percent of The effectiveness of a capital market development strategy will fund assets for a maximum of one year, with Board approval. Other institutional be dependent upon overall macro-economic conditions in the country. investors, such as pension funds and insurance companies, are not significant Egypt’s future fiscal and monetary policies will have a substantial impact. investors in the Egyptian equity market. Many factors partially explain Governmental borrowing can crowd out the private sector’s efforts to raise this limited role. Pension funds lack professional third party management funds, from bank lending, from the sale of equities and the issuance of requirements, and are significantly underfunded. Investments of insurance corporate debt. The interest rate on sovereign debt is the baseline for pricing companies and private pension funds are concentrated in government debt private sector securities. As the private sector has a greater risk profile, it and bank deposits, although regulations allow for up to 20 percent investment must offer a higher return than government securities. If the government’s in equity and up to 20 percent investment in corporate bonds. borrowing needs continually consume the bulk of the available investment Efforts to develop a venture capital / private equity (VC/PE) sector capital and if the interest rate on sovereign debt is so high that companies in Egypt have had mixed results. As of 2010 (last figures available) there cannot pay a higher cost of capital, it is unlikely that any capital market were 19 licensed venture capital firms. Several major private equity firms, strategy will be successful. Similarly, the stability of a country’s currency including EFG-Hermes and Citadel Capital are major presences in the will have a profound impact on foreign investors. An unstable currency, that Egyptian capital markets. Ideally, these firms should be early entry investors poses a high risk of exchange rate decline, is a significant investment risk for in first stage companies, providing investment funding and management foreign investors. 76 Financial Development and Inclusive Growth The Development of the Capital Markets 77 In order for Egypt’s private sector to expand, the government must limited free float of major public companies. The lack of sufficient free float address the problem of “crowding out”. A macro-financial issue of concern in companies on the EGX adversely affects the overall turnover rate on the is the potential “crowding-out” of credit to the private sector by government EGX, lower than all but one of the comparison countries. This adversely borrowing. As the government deficit grows, public sector borrowing will affects the overall development of the EGX as a viable secondary market. consume available bank lending to the private sector. In 2010, a World Bank It also adversely restricts or hampers efforts to develop an institutional document noted a sharp decline in the already falling ratio of bank’s loans investor base in Egypt. Simply put, pension funds, insurance companies, and to deposits, from 55.9 percent at the end of 2008 to 51 percent at the end mutual funds that would like to increase their allocation of assets to the of 2009 and 48.5 percent at the end of 2010. While the limited growth of equity market are hampered by the lack of available shares in the “blue chip” credit to the private sector in 2009 and 2010 was mainly due to the post-2008 investment grade stocks. economic situation, since 2011, government borrowing is a significant macro- The limited availability of investment financing sources to the private economic issue that will undermine any effort at private sector capital market sector has been a long-standing problem. In a 2010 report, the OECD estimated development. Credit allocated from the banking sector to the government-to- that only roughly 3 percent of businesses access capital markets. The EGX to total credit has been rising to reach 62 percent of total credit, while that to date has not provided an effective alternative source of capital. Little financing the private sector credit dropped to 28 percent as of April 2013 has been made available for enterprises through the primary capital market. An effective legal system, in which contractual agreements are Even during its high point, there were few IPOs on the EGX, less than in honored, is essential to capital market development. Investors must be other comparison developing market countries. As discussed elsewhere in confident that their investments will be honored in any legal proceeding. this report, the private debt market in Egypt is even less developed than the In this regard, the legal actions in 2011 to rescind privatization deals that equity market. While the availability of bank lending is greater, it has been occurred years, and even decades, before will be a substantial impediment concentrated in short-term lending to the larger corporations. to future efforts to privatize SOEs. This is particularly significant if the A three-prong development strategy is proposed. Expanding the rescission efforts are brought against successor owners of a company, who functionality and capacity of the EGX is the first prong. Building a robust purchased an ownership interest in good faith negotiations from the persons institutional investor base to increase the supply of investment capital and involved in the original disputed transaction. While governmental corruption the demand for equity securities is the second component of this strategy. and cronyism can have pervasive and deleterious consequences on national Finally, the third prong focuses on growing the number of public listed economic development, the proper recourse is through criminal prosecution companies on the EGX through three complementary initiatives. of the culpable individuals and not through rescission of valid commercial agreements with successor bona fide third parties who had no involvement in Building the Capacity of the EGX the questioned transaction. The EGX has a narrow range of securities products and few ways of engaging in profitable investing. There are no exchange-traded funds. The Tailoring the Strategy to Egypt EGX does not have derivatives products and there are no standardized An effective capital market strategy should be built upon and tailored equity options. The EGX operates with a number of prudential rules that are to reflect the economy of the country, its investment base and its culture and intended to reduce trading volatility but also reduce market liquidity and history. There is not a single capital market’s development strategy that is efficiency. These rules include limitations on intra-day trading, limitations on applicable to every emerging market country. The specific characteristics of margin trading in some stocks, a prohibition on short selling, price limits and each country are different. In Egypt, the government has traditionally played trading halts. The statutory prohibition on brokers engaging in proprietary a dominant role in economic development and in the allocation of finance. trading, although likely ineffectual, also adversely affects market efficiency Historically, government ownership or government participation in the and liquidity. These limitations are common in new, undeveloped markets. largest companies and in startup companies or developing industries has been Reducing market volatility is also a common regulatory priority in new significant; government ownership continues to be a defining characteristic markets. However these types of restrictions should be viewed as temporary of the economy in Egypt. and transitory. If a secondary market is going to develop into an effective After a decade of efforts at privatization, the government continues to vehicle for price discovery and investment opportunities, it must evolve and be a significant owner in companies listed on the EGX, and in many of the its rules must, over time, balance the risks of volatility with the benefits of major financial services companies. This pattern must be carefully addressed market liquidity. in a comprehensive capital market strategy. The continued ownership of Regulatory policies designed to reduce market volatility can have large or controlling interests in privatized companies is reflected in the the unintended consequence of contributing to market volatility. As a 78 Financial Development and Inclusive Growth The Development of the Capital Markets 79 consequence of this combination of factors, the only profitable investment market momentum trading strategies in which investors buy stocks as soon strategy available on the EGX is “long-only” momentum investing. While a as the price rises. Inevitably, this can lead to overpriced stocks, which then rising stock market is always desired, a stock market that is structurally drop precipitously as soon as the buying momentum decreases. This sharp biased to the long-side inevitably becomes a volatile momentum-driven upward and downward movement is an example of undesirable market market that rises too far and too fast. When stocks become overvalued, they volatility. Frequently the retail investors who are late to buy and late to sell drop dramatically. Well-regulated short selling is an effective method of suffer the greatest harm. Well-regulated short-selling, in which persons can counteracting excessive momentum-driven market runs. The participation profit by selling when price momentum is going up and then buying when of proprietary trading by intermediaries can offset the “irrational optimism” stocks are falling provide an effective counterweight to momentum buying of retail investors. and selling. By modulating these sharp up and down movements, they EFSA should strongly support EGX efforts to expand and diversify improve price discovery and reduce volatility. Intra-day trading, when it is available traded instruments such as ETFs and EGX efforts to develop broad- carefully regulated, can also improve market liquidity and price discovery. based index futures and standardized single stock options products. There are The Egyptian regulatory strategy of limiting intra-day trading to the most a multitude of financial derivatives products, with very different purposes, liquid securities, by controlling the quantity of shares in one company that one very different risk characteristics and very different levels of complexity and investor can purchase intra-day, and by increasing the capital requirements leverage. In the early stages of capital market development, a conservative for firms whose clients trade intra-day is a sound strategy. approach to derivatives trading is the norm. This is understandable, as The Capital Market Law prohibition on proprietary trading by licensed derivatives, with their inherent complexity and leverage, can be perceived as brokers should be relaxed. One of the core principles of stock exchanges is contributing to market volatility and instability. However, as markets develop the concept of price discovery. By bringing together all buyers and sellers and mature and market professionals and institutional investors become more and permitting them to submit and disclose prices to buy and sell a security, sophisticated the benefits of derivatives products can outweigh the deleterious the market becomes an engine to discover the best price for that security. consequences. It is a recognized phenomenon that the trading of derivatives in The more buyers and sellers in the market, the better the price discovery a sound regulatory environment in which suitable risk management measures function works. Similarly, if there are a greater number of knowledgeable are in place helps to smooth significant volatility swings. investors willing to provide short-term and consistent market liquidity, price Interest rate derivative products provide benefits to the banking discovery is improved and price volatility, due to a short-term imbalance sector by providing tools to manage overall bank risk and to reduce a bank’s between buyers and sellers, is reduced. Brokerage firms trading in their own exposure to sudden changes in interest rates. Futures contracts based upon proprietary accounts can play an important role in this process. Conversely, if broad market indices can be useful tools for institutional investor portfolio brokerage firm trading is not carefully supervised, firms can take advantage managers. Most importantly, when derivative products are standardized of their superior access to market information, particularly to information for trading on an exchange, there is a reduction in market opacity and the on trade imbalances and on upcoming trades by large players. For this risks inherent in trading non-standard derivative contracts OTC. While it reason, the Capital Market Law prohibits brokerage firms from engaging in is not recommended that EFSA and the EGX immediately permit any and proprietary trading. all securities products to be traded, the development of the EGX would be Unfortunately, the prohibition is ineffective and counterproductive. facilitated by an incremental plan to trade some forms of derivatives and It does not apply to firm trading that is conducted by an affiliated, but other products. A useful first step would be to develop broad-based index separately created, company that is under the common control of the firm’s futures and standardized options on individual stocks. These can contribute holding company. All of the major brokerage firms in Egypt operate as to effective price discovery and market efficiency. A transparent plan and licensed subsidiaries of a holding company that controls a separate entity, timetable to expand the products offered and to expand the types of trading typically called a private investment company or venture capital firm that offered is an important first step in market development. actively trades for proprietary accounts. This structure makes it difficult to EFSA and the EGX restored intra-day trading on May 2013. While effectively regulate and monitor trading that is the functional equivalent of short-selling is often viewed as contributing to market volatility and on a proprietary trading account at a brokerage firm. It also means that this occasion used to facilitate market fraud, in reality well regulated short- trading is not incorporated into the capital adequacy calculations for the selling typically improves market liquidity and price discovery and reduces licensed brokerage firm. A better approach to this problem would be to permit volatility. When markets prohibit short-selling, they create a structural bias proprietary trading through the licensed brokerage firm where it could be to upward price movements. Simply put, without short-selling investors can monitored more effectively. Improved transparency of industry practices only make money when a market goes up. This structural bias encourages would also improve public confidence in market integrity. 80 Financial Development and Inclusive Growth The Development of the Capital Markets 81 EFSA should have the regulatory authority to license brokerage firms investment objectives focusing on active trading. Professional intermediaries who without consideration of “market need” and to revoke brokerage licenses. The provide daily liquidity are also vital. Foreign investors, who bring sizeable amounts number of licensed brokerage firms in Egypt has remained largely constant for a of capital and investing sophistication, are typically important participants in decade. Because a small number of firms dominates the industry, many brokers emerging markets. The absence of a meaningful domestic institutional investor base are barely functioning or dormant. Because of this excess capacity, EFSA has been has been a significant constraint on EGX development. reluctant to license new firms, because the licensing decision requires consideration A robust institutional investor sector should include pension funds, of “market need” for more firms. Because it is difficult for new entrants to obtain insurance companies, large professional investment pools and mutual funds. Life a license, new firms must instead purchase an existing license from a dormant insurance companies and pension funds are financial intermediaries with long licensed firm. These firms retain their licenses even if inactive because EFSA investment horizons who can provide long-term investments and professional lacks the authority to revoke licenses because of inactivity. This is an example market sophistication to an equity market. As professional managers control of unintended and unwarranted regulatory benefits conferred on firms. A more existing pools of assets, they can be early entrants into a developing equity effective approach would be to revoke licenses for firms that no longer are active market. Mutual funds can also perform a similar and complementary role. and then award licenses to new entrants without regard to “market need”. An However, mutual funds must first build an investor base of individuals and this effective open capital market should be based upon success leading to benefits and frequently occurs only after a stock market has begun to grow. As such, they failure leading to consequences. Firms that fail should not benefit from having once will typically become significant participants in an equity market at a later received a license. stage of development than pension funds and insurers. EGX problems of limited free float and low liquidity and turnover could be Egypt’s regulatory system can be a useful tool in building the ameliorated by an orderly, transparent and disciplined government sale of some institutional investor sector. In Egypt, the appropriate regulatory agencies portion of its shares in companies that are publicly listed on the EGX. This would should review their prudential guidelines on asset allocation to ensure that provide a stimulus to the EGX. The resulting increase in the number of available insurance companies and pension plans allocate an appropriate portion of shares of the “blue chip” Egyptian companies would also assist in the growth of an their assets to equities. This approach would be highly beneficial to equity institutional investor sector in Egypt. In Egypt, the government has historically market development and it would be consistent with international best played a pivotal role in economic growth. Given how engrained this role is in Egypt, it practices for the regulation of insurance companies and pension plans. In the would be unrealistic to abandon it entirely. However, the government must recognize same vein, the legal proposals to require pension plans to retain professional that the benefits of its role in the economic development of specific companies will investment managers and permit the use of pooled investment vehicles, would likely decline over time as the company grows and becomes well established. This is also achieve both objectives–market development and effective regulation of the basis for the privatization efforts of the previous decade, as well as the various these institutional investors. public-private partnership projects that have been undertaken. While there have Parliamentary action to adopt the proposed amendments to the private been some well publicized instances in which a privatization program has resulted in benefit plans Law 54 of 1975 should be a high priority. The existing law preferential contracts or ownership transfers, these occasions should be recognized is out of date and there are significant gaps in regulatory coverage. EFSA as failures of execution rather than a fundamental flaw in the privatization process. authority should encompass all private pension and benefit plans, not just Building a Robust Institutional Investor Base those in which employees contribute. Private funds should be required to have internal oversight boards, and fund accounts should be externally During the past decade, domestic individual investors played a audited annually. Pension fund officers, directors and asset managers should dominant role fueling EGX growth. A strong pool of retail investors is an be required to have sufficient professional qualifications and appropriate important component of a growing equity market. However, it may not be the fiduciary standards should apply. EFSA should have full licensing authority, optimal “buy-side” for long-term market development. Individual investors including application of a fit and proper standard. Funds should be permitted often do not provide investing sophistication, critical to price discovery. They and encouraged to outsource asset management to independent third parties. are frequently momentum investors who invest in a rising market and sell Funds should be required to disclose publicly the fund’s expense ratios, and when a market falls. The relatively low level of efficient price discovery in provide clear explanations of fund benefits, including risks and uncertainties. Egypt is likely a consequence of the dominance of retail investors. A successful equity market requires a deep and diverse pool of investors Increasing the Number of Listed Companies with different risk capacities and time horizons. This pool of investors should Stock markets are not the exclusive vehicle for providing companies with include individuals, institutional investors and professional traders. It should access to investment capital. It is one of several options. A private company include investors with long-term investment horizons and investors with short-term seeking investment funding can also obtain it from bank lending, from 82 Financial Development and Inclusive Growth The Development of the Capital Markets 83 government loans or investments, from strategic private investors, including stimulating the Egyptian economy. The government should carefully review other companies, VC/PE firms, foreign companies and banks and through the merits of projects and the terms of the relevant project. Going forward mergers with other companies. The decision to engage in a public offering of on the most important and most attractive PPPs would not only provide a equities is based on whether this provides the most attractive source of funding. stimulus to the Egyptian economy at a time when it is most needed. It would When a stock market is at an early stage of development, valuations on that also be an important signal to foreign investors that Egypt should continue market may be low, resulting in a high cost of capital. The costs of public to be viewed as an attractive emerging market country, as it has been for the listing, including greater disclosure burdens and other legal requirements past decade. may also weigh against public listing. An increase in the number of public Completion of the reorganization and privatization of the state-owned listed companies may not be the initial catalyst for stock market development. insurers should be a priority. EFSA has taken the important intermediate steps Instead, it may be a consequence of successful market development. of reorganizing and separating the life and non-life programs. Rationalizing Frequently development efforts to build equity markets in emerging the premiums for MTPL insurance was also a necessary and important step. countries focus efforts on development of a special small-cap market for the The critical next step will be to complete the privatization program through smallest and least seasoned companies. The Alternative Investment Market IPOs. In addition to improving the overall insurance services sector, this will (AIM) in London is the best-known example. In fact, AIM is the model used by also result in adding two large new companies to EGX. EGX for its NILEX platform. To date the success of this model is uncertain. Future government privatization efforts should be conducted through The instances of companies that migrated successfully from AIM to the LSE public offerings via the EGX. In countries where the government plays a have been few. The valuation of companies on AIM has been low and the key strategic or dominant role, the creation of a government exit strategy is trading liquidity has been disappointing. This pattern has been repeated in often a critical missing piece of the puzzle. In many countries, the process other countries, large and small. NILEX has, to date, followed this pattern. for government exit, via privatization or sale, can be distorted by corruption Egypt should emphasize the importance of growing its PE/VC industry. or cronyism. The lack of a well-developed and disciplined government exit An alternative model emphasizes the use of venture capital/ private equity strategy can result in a government retaining an ownership interest for years as the initial provider of investment capital and managerial expertise to or decades, well beyond the period of development. One of the benefits of small promising companies. First stage companies may be too speculative a functioning, transparent secondary market, is its use as a vehicle for a for public investors and too small to be of interest to institutional investors. governmental “exit strategy”. Instead of engaging in a private, negotiated The fixed costs of being a public listed company may be too great and too deal to privatize government ownership, which can create the perception burdensome for first stage companies. VC/PE can be more effective sources of corruption or cronyism, a government can sell its interest via an equity of investment capital. In this model, the listing and IPO should be viewed offering on a stock exchange. The market will set the fair price, and all as the goal for the second stage of growth, after the company has become investors can participate equally. viable and has grown to a sufficient size. The companies that succeed and A deeper and more liquid EGX will provide share valuations that grow following private investment can go public through an IPO. The IPO incentivize private companies to go public. Greater institutional investor provides the exit strategy for VC/PE, and given the availability of a relatively demand, combined with a more robust NBFI sector will, if successful, promote mature exchange-based market such as EGX, opportunities exist that many higher share prices. It will raise price/equity ratios and make listing more less mature markets cannot offer. The investing public benefits from being attractive. This will attract larger established companies who have not been able to invest in a larger company with a track record of performance and a interested in public listings at the low prices historically on the EGX. To that clearer understanding of further investment potential. end, the new listing rules issued by EFSA on February 1st, 2014 allowed a Egypt should renew its commitment to public-private partnership wider range of companies to be listed, extending to newly established ones development initiatives. The private-public partnership model is the analogous and those not meeting the 5% return on capital requirements. Such exceptions first stage for companies that are government-owned. The government is able are conditional to proving credibility of the founders and providing additional to continue to maintain an ownership interest and the company gains access disclosures including an independent financial advisor report addressing the to private sources of investment capital and business expertise. The successful future prospects of the company and its valuation. completion of the PPP can transition into government divestiture through a transparent public offering process that avoids the taint of corruption or The Importance of Investor Protection Regulation to Equity Market Development cronyism. Following January 2011, several PPP projects are in limbo due to An effective equity market must be deep, liquid and efficient. Moreover, government uncertainty over the merits of the projects, and possibly because it must be fair. An effective regulatory program must encompass a wide array of concerns over the terms of the project. These projects could be vital to of duties. The chapter on NBFI regulation in this report discusses the areas 84 Financial Development and Inclusive Growth The Development of the Capital Markets 85 where EFSA should build its capacity. Several of the recommendations in fixed income markets and to support mutual funds were enacted. While the that chapter are intrinsically related to the developmental strategy described January 2011 revolution temporarily put some of these reforms on hold, little in this chapter. They are summarized below. if any regression appears to have occurred. Mutual fund sales materials and sales practices should be In spite of the above-mentioned efforts, liquid secondary markets comprehensively and consistently regulated. EFSA does not directly regulate remain absent in government debt and the corporate bond market is still mutual fund sales practices and personnel. EFSA does not review fund underdeveloped and nascent when compared to the banking sector and equity sales materials, other than the prospectus. Mutual funds should be required markets as a source of funding. This can be explained by the existence of to make NAV publicly available on an Internet site daily. Funds should structural factors related to excess liquidity and bank dominance as a source be required to send investors updated disclosure on fund performance, of funding for the government and non-government fixed income markets. investment strategies and information on fund holdings on a regular basis, One additional reason is the fact that debt market development reforms are at least annually but preferably semi-annually or quarterly. processes that develop gradually over time and the sustained effort required EFSA and CBE should develop a uniform procedure for regulation of was partially interrupted by the revolution. This section takes into account mutual fund sales practices by bank employees. While the Capital Market the most significant achievements in government and non-government Law executive regulations impose suitability or “know your customer” fixed income markets accomplished during the two phases of the Financial requirement on fund sales personnel who work for a mutual fund or brokerage Sector Reform Program (2004–2008 and 2009–2012) and proposes a series of firm, CBE has not adopted a parallel requirement for bank employees who priorities and specific recommendations to reinforce ongoing reforms. sell mutual funds. Because banks actively sell mutual funds they originate Money Markets through their extensive branch networks, this regulatory inconsistency should be addressed. Well-functioning money markets are essential for the development of both government and non-government fixed income markets. Not only do they enable issuers and investors to manage liquidity more efficiently, Fixed Income Markets1 but they also lower liquidity risk and the cost of inventory holdings through repo markets. The latter are essential to support lengthening of the yield Introduction curve and liquidity, including market-making mechanisms. Money markets Starting in 2004, the government embarked on implementing the are also central to effective monetary policy through the use of indirect home grown Phase I (2004–2008) of the financial sector reform program. The instruments. Central Banks have a dual responsibility in developing efficient program was designed along four main pillars: (i) introducing a comprehensive money markets. The first is effective liquidity management schemes through and transparent Monetary Policy Framework; (ii) improving the functioning accurate liquidity forecasting and timely and effective liquidity draining of the Foreign Exchange Market; (iii) implementing Banking Sector Reform; or injection operations. This includes a careful choice of monetary policy and (iv) strengthening the Non-Bank Financial Sector, including the equity, instruments that are supportive of money market efficiency. fixed income, insurance, financial leasing and mortgage finance markets Liquidity management may prove challenging in economies with chronic Relevant progress was achieved in fixed income markets, particularly excess liquidity due to high sterilization costs, inaccuracy of liquidity forecasts in the organization of a reliable primary market for government debt, capital by other government institutions and the need to coordinate closely with the market regulations, and the development of an active and promising mutual Ministry of Finance’s issuance policy. The second is the development of an fund industry based on money market mutual funds. This is in addition operational framework conducive to facilitating money market transactions. This to the significant progress in setting the entire regulatory framework for includes efficient clearing and settlement arrangements, price dissemination securitization and issuing asset-backed and mortgage backed securities. mechanisms and robust and tax neutral repo frameworks. Egypt’s money Phase (II) of the reform plan was designed for the 2009–2012 period markets are relatively shallow as a result of the combined effects of chronic excess that had a stronger focus on capital markets. Reforms in government debt liquidity related to past capital inflows, and a still developing money market markets were taken to a level that placed Egypt in a position to attract greater operational framework. Most transactions take place between the Central Bank international investor interest as well as implementing a series of important and banks in the form of overnight deposits, auctioned short-term non-tradable changes in the non-government fixed income market. The government yield deposits at the Central Bank to drain liquidity and auctioned short-term repos curve was lengthened to 7-years on a sustainable basis, a comprehensive to inject liquidity2 (Table 3.9). The evolution of the CBE’s liquidity management OTC secondary market architecture was designed, yet not implemented, instruments and the operational money market framework as well as suggested and several regulations to reduce the regulatory burden on non-government improvements is described below. 86 Financial Development and Inclusive Growth The Development of the Capital Markets 87 Table 3.6: Monetary Policy Instruments in Egypt the market is still developing. However, they have yet to begin addressing on a sustainable basis effective management of structural excess liquidity Instrument Features Launch date (a condition necessary to support a well-functioning fixed income market. Reserve requirement Currently 10 percent of local currency Launched in 1957 Although, political uncertainty brought on by the revolution has reduced deposits excluding CDs 3 years and excess liquidity, it can be expected that once the situation stabilizes capital above, unremunerated inflows will resume, and structural excess liquidity will present similar Overnight interest Standing deposit and lending facility Launched in 2005 rate corridor Overnight rates fixed by Monetary challenges to those existing prior to the revolution. Policy Committee Management of structural excess liquidity is a complex and delicate Auctioned CBE bills 7, 14 days Launched in 2005 until 2008 task which invariably involves the need to make certain trade-offs between Tradable monetary policy and debt market development. Such decisions involve policy decisions relating to legal, institutional and financial matters among others. Auctioned deposits currently 7 days fixed rate auction at Launched in 2007 mid-corridor, more tenors previously This is a common situation faced by most EMEs that are exposed to large capital Non tradable inflows. The most successful experiences are those that have developed schemes Auctioned repos 7 days Launched in 2011until 2013 supportive of debt market development (e.g. Mexico, Brazil, and South Africa). T-bills as collateral Decisions to be taken by Egypt to develop a sustainable structural liquidity management scheme should include at a minimum the following issues: Source: CBE. ϘϘ Coordination between the CBE and the Ministry of Finance regarding issuance policies and choice of instruments.5 Implications of Monetary Policy Operations and Excess Liquidity ϘϘ Comprehensive analysis of the impact of the chosen scheme on In 2004, when Phase I was launched, the CBE was already confronted overall debt market development. with a pressing need to sterilize excess liquidity which was aggravated by ϘϘ Ensuring consistency between the structural sterilization scheme large capital inflows. Since then, CBE has completed a series of successful and monetary policy instruments to manage seasonal liquidity reforms aimed at modernizing monetary policy and liquidity management fluctuations, as well as safeguards to enable the CBE to intervene with the ultimate goal of implementing inflation targeting. In 2005, the CBE with extraordinary amounts in situations of financial stress. moved from a quantitative operational target (excess reserves) to a price target (overnight inter-bank rate; launched an interest rate corridor;3 and ϘϘ Permanent agreement in place regarding the manner in which started issuing CBE instruments as the primary instruments for liquidity sterilization costs are shared between the CBE and the Ministry of management through open market operations). These measures enhanced Finance. Multiple models exist ranging from one institution bearing monetary policy operations facilitating effective liquidity management with the full cost to shared cost agreements. the aim of implementing in the future a full-fledged inflation-targeting Money Market Instruments and Organization regime.4 In addition, CBE initiated a very ambitious reserve management program initiating an efficient and sophisticated model that has served Transactions in the Egyptian interbank market are rare but can include to strengthen the operational management of its balance sheet. All these unsecured lending, T-bills and documented and undocumented Repos. T-bill measures have contributed to partially fulfilling the pre-conditions to OTC trading is the most active market with prices being reported on Reuters developing a more efficient money market. and settled at CBE on T+0. The first open market operations launched in 2005 to sterilize excess Since 2010, the CBE has taken relevant steps to enhance the efficiency of liquidity were CBE tradable CDs, which could be bought by both domestic the T-bill market. These include separating sell-buy backs from outright sales and foreign investors. They were replaced in 2007 by non-negotiable CBE in price collection and dissemination, publishing a daily T-bill yield curve; and auctioned deposits. Tradable CDs were eventually eliminated given the initiating a project to organize a market-making scheme for T-bills. The latter perverse effect they were having on attracting further capital flows. In 2011, is essential for the development of the money market but should be consistent after the revolution, the CBE introduced auctioned 7-day repos to address with ongoing actions to develop a comparable scheme for T-bonds. Ideally, eventual liquidity shortages. T-bills and T-bonds should trade in a unified OTC market architecture. From an operational perspective, the instruments launched by the CBE Repos between banks and institutional clients are generally conducted represent a step in the right direction. They reflect the dynamic approach that in the form of undocumented sell-buy backs using T-bills and T-bonds as a central bank needs to take when designing open market operations while collateral. There are two ongoing initiatives led by the CBE for repos on 88 Financial Development and Inclusive Growth The Development of the Capital Markets 89 T-bills and by the Ministry of Finance and EFSA for repos on T-bonds. Ideally, Debt indicators inevitably worsened after January 2011, in light a single repo framework should be designed to accommodate both types of of increased uncertainty and challenging funding conditions. The average collateral. The development of a sound repo6 framework including a standard maturity of the debt dropped to 1.3 years by the end of 2011, while T-Bond master Repo agreement and clarifying the tax and accounting framework is issuance was interrupted from February 2011 to July 2011. essential to the further development of the money market. In spite of drawbacks in the debt profile, the reforms introduced since 2004, particularly those introduced after 2009 as will be explained below, Primary Markets provide solid foundations for a renewed process of debt market development Government fixed income markets. Primary Market policies as enabling conditions in the political-economy front stabilize. An agenda of of government debt play a fundamental role in enhancing competition, primary market policies should be formulated taking into account lessons improving price formation and ensuring a stable and cost-effective funding learned from reforms already implemented as well as the remaining program. Well-articulated issuance strategies support the development of a challenges still to be addressed in two key areas: (i) issuance policy and (ii) benchmark yield curve by providing an adequate set of instruments issued at PD system. reliable prices and covering a wide spectrum of maturities. Policies include Issuance policy. Egypt’s issuance policy has been focused on the use the careful selection of securities, the design of auction calendars capable of of tradable, standardized securities and of re-openings of T-Bonds since sustainable implementation and the creation of a competitive environment, 2004. Despite progress, a needs assessment carried out by the World Bank usually involving PDs. in 2007/08 pursuant to a request from the Ministry of Finance identified Egypt has made considerable progress in its primary market policies some key inefficiencies: (i) long-term maturities were being issued before through a gradual plan of reform initiated in 2004 and reinforced at a the consolidation of shorter-term liquid benchmarks; (ii) bonds with second phase in 2009/10. This set of reforms, discussed in detail below, very close maturities were being issued in the same year, causing debt has served to help transform Egypt’s debt profile (Figure 3.1). As a result, fragmentation; and (iii) re-openings followed an irregular pattern with the share of tradable standardized securities (T-Bills and T-Bonds) considerable time-lags. began to predominate, reaching 62 percent by September 2011, against A second wave of reforms to tackle existing inefficiencies was 28.3 percent in December 2004. Similarly, average maturity of the debt implemented in the period 2009/10. Issuance was organized with the increased from 0.4 years in 2004 to a peak of 1.73 years in November 2010, goal of improving benchmark building and price discovery in the primary and the percentage of debt maturing in less than 12 months (a measure markets. The main elements included the gradual process of consolidation of of refinancing risk) dropped from 92 percent in 2004 to levels around 60 benchmarks from short to longer-term tenures; and the enhanced organization percent by the end of 2010. of auction calendars of government securities’ maturity dates. Figure 3.1: Evolution the Securities of Debt Domestic Structure of Domestic Outstanding Debt (EGP Bn, %) (2004–2011)7 In 2009, the gradual process of consolidation of benchmarks was EGP bn Non-standard Securities Treasury Bills initiated with re-openings of 9– and 12–month T-Bills. By reducing the % Treasury Bonds Standard Securities (% of Total) number of lines of these T-Bills and increasing their average sizes by at least 1,000 70 62.1 two-fold, Ministry of Finance improved liquidity and created better short- 900 57.2 60 term price references to launch longer-term instruments. Together, these 221 800 51.4 two instruments, 9–month and 12–month T-Bills, represented more than 60 203 700 44.6 124 50 percent of T-Bills issued in 2009. 41.1 35.3 600 29.9 65 74 350 40 T-Bond issuances that had been interrupted since June 2008 resumed 500 28.3 58 252 282 in January of 2009 following an approach that started with shorter maturities 146 206 400 106 30 (3–year T-Bonds) before advancing to 5–year and longer-term T-Bonds. This 300 22 44 approach proved beneficial for price discovery with a potentially significant 20 71 91 reduction in funding costs.8 However, the T-Bond program still lacked 200 385 386 363 235 347 356 349 10 regularity and organization of auction calendars, and maturities that could 100 193 enhance the size and liquidity of these instruments. Currently, the T-Bond - - program becomes more regular, and new tenors have been introduced. A Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 thorough reform of quarterly auction calendars in 2010 reinforced the process Source: CBE; EGX. of gradual benchmark building. The main principles adopted included: 90 Financial Development and Inclusive Growth The Development of the Capital Markets 91 Standardization of benchmark maturities: Focus on issuances of ϘϘ Figure 3.3 shows that as of January 2012, more than 30 percent (LE 72 bn) T-Bills of 3, 6, 9 and 12–months; and T-Bonds of 3, 5, 7 and 10–years. of the T-Bond stock will mature in 2013. There is significant concentration in July ϘϘ Smaller number of lines and larger benchmark amounts: Greater use 13, with maturing T-Bonds totaling LE 24 bn in that month alone. Measures to of reopening and definition of target sizes of benchmark instruments. mitigate refinancing risk should rank high on the agenda of the authorities in the near-term. ϘϘ Fixed pattern issuance calendar: T-Bills would be auctioned every week and T-Bonds every other week in a predictable manner. Figure 3.3: T-Bond Issuances in 2011 ϘϘ Organization of maturity dates of T-Bond benchmarks: T-Bond Government Bonds Issuance in 2011 (EGP Bn; %) maturity dates were standardized to avoid bunching of maturities 3.50 18.00 Nominal Amount (EGP Bn) LHS Yield (%) RHS and better manage refinancing risk. 15.46 15.77 15.75 15.85 15.93 15.97 16.00 3.00 14.45 Following this new approach, by the end of 2010 Egypt was able to 12.80 13.04 13.10 13.29 13.35 13.48 13.50 13.41 13.58 14.00 14.25 14.50 14.22 14.00 attain two important achievements: (i) the stock of T-Bonds grew significantly 2.50 11.61 12.32 11.63 12.00 from LE 124 bn in December 2009 to LE 203 bn in December 2010; and (ii) 2.00 larger size benchmarks at key maturities were created. 10.00 A noteworthy consequence of the increase of average benchmark sizes 1.50 8.00 was the impressive growth of Egypt’s market capitalization in the GEMX Jan-14 Jul-13 Aug-14 6.00 index. Egypt had the second highest increase in market capitalization among 1.00 Jul-13 Aug-14 Jul-13 Aug-14 Aug-14 4.00 the 24 emerging markets included in the index, moving from LE 62 bn in Dec Oct-14 Oct-16 Oct-14 Oct-13 Sep-15 Oct-14 Oct-16 Oct-14 Oct-16 0.50 Feb-17 Oct-16 2009 to LE 103 bn in Dec 2010.9 In addition to creating enabling conditions for Aug-20 Oct-18 Oct-14 Oct-16 2.00 enhanced liquidity and reforms in the secondary markets, the consolidation - 0.00 of benchmarks also paved the way for improvements in the PD system. Jan 2011 Jul 2011 Aug 2011 Sep 2011 Oct 2011 Nov 2011 Dec 2011 Figure 3.2: Egypt’s Market Capitalization in GEMX Source: CBE; EFSA. % change Figure 3.4: T-Bond Annual Maturity Profile (as of Jan 2012) GEMX Market cap % change GEMX Market cap since EGP bn (EGP Bn; % change yoy) (yoy) EGP bn (EGP Bn; % change since Nov 2008) Nov 2008 Government Bonds Annual Maturity Profile (EGP Bn; %) 140 80% 140 180% 80.0 35.0% Market Value (EGP bn) Market Value (EGP bn) Nominal Amount (EGP Bn) LHS % of Total RHS 30.2% % change (yoy) 66.80% 119 120 70% % change since Nov 2008 160% 120 120 70.0 30.0% 119120 102103 105 108 106105 103104103 102 104 60% 108 140% 105 106105 104 100 94 94 95 100 100 102 103 103 103 102 104 60.0 94 94 95 100 120% 23.2% 25.0% 81 87 50% 87 80 79 80 81 100% 72 75 79 50.0 40% 72 75 63 62 65 20.0% 60 57 57 61 59 60 61 60 60 61 61 60 63 62 65 80% 16.9% 59 60 52 30% 47 49 57 57 52 40.0 12.6% 45 46 60% 40 40 15.0% 20% 40% 30.0 20 10% 20 20% 7.5% 10.0% 20.0 0 0% 0 0% 5.7% 10.0 5.0% 3/1 7/1 11/1 3/1 7/1 11/1 3/1 7/1 11/1 11/1 3/1 7/1 11/1 3/1 7/1 11/1 3/1 7/1 11/1 1.3% 2.3% 09 09 09 10 10 10 11 11 11 08 09 09 09 10 10 10 11 11 11 0.4% 0.0 0.0% Source: EGX. 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Source: CBE. The process of consolidation of T-Bond benchmarks suffered a setback after the revolution of 2011. T-Bond issuances were interrupted from February Primary dealers. Egypt’s PD system was introduced in 2002 and reinforced to June and irregular after resuming in July 2011 due to continuing turbulent in the context of the 2004 reforms. PDs’ rights include exclusive participation in times (Figure 3.2). The implementation of liability management techniques primary markets and commissions on customer’s winning bids. Obligations consist (such as buybacks and switches) to mitigate refinancing risk of large T-Bond of minimum volumes in submitted and winning bids by each of the 15 PDs, as well as instruments, especially those coming due in 2013, were also delayed. minimum turnover and provision of two-way market quotes in secondary markets. 92 Financial Development and Inclusive Growth The Development of the Capital Markets 93 As in the issuance program, several areas for improvement were similar level following the revolution at LE 2.6 billion between January and detected during the WB needs assessment of 2008. PDs lacked motivation and June 2011. For the purpose of this report, in addition to pure corporate bonds commitment to perform, while the Ministry of Finance was only monitoring (LE 6.9 billion), securitized bonds (LE 6.4 billion) and public juristic13 bonds compliance to primary market obligations. Underperformance in secondary (LE 10 billion) will also be considered as part of the non-government bond markets was linked to problems in the issuance program discussed above, but universe, as they provide an overview of existing and potential supply and also due to: (i) lack of incentives for PDs to compete among themselves; and demand conditions in Egypt for non-government fixed income instruments. (ii) hurdles in secondary market architecture, including absence of market making infrastructure (e.g. no electronic trading platform with an auto match Instruments function and securities lending facility). The latter is further discussed in the Corporate bonds. Pure corporate bond issues are concentrated in six section on secondary markets below. large recurrent high quality firms,14 four of which are also blue chips in the In parallel to improvements in the issuance program, competition among equity market with 19 percent of the Exchange market capitalization. There PDs was strengthened in 2010 via enhanced performance monitoring and the are six bond issues outstanding at LE 6.9 billion (30 percent of total) with publication of league tables with the top five performers in both the primary maturities ranging from 5 to 6 years for fixed coupon bonds to 7–years for the and secondary markets. The Ministry of Finance developed a methodology sole floating rate bond (Table 3.11). Average size of issues at around LE 1 bn based on quantitative and qualitative performance indicators that according is reasonably in line with the average size of government bond placements to authorities were well received by PDs, with positive impact on their activity. within the LE 0.5–2.5 bn range and building up to issue size of LE 6 bn. Most A comprehensive review of the PD convention was underway just prior to the outstanding bonds have an embedded call option. revolution of 2011. The optimal timing to launch the new convention depends An example of corporate bond market dynamics is the issuance by on the pace of reforms in the secondary markets that would create an enabling Mobinil in January 2010 of a LE 1.5.billion 5–year bond. It was placed environment to strengthen PD’s obligations and their compliance, especially utilizing two modalities: LE 1.4 billion under an Egyptian private with respect to bid and ask spreads on electronic trading platforms. placement15 tranche oversubscribed by 1.5 times and offered to institutions Non-government fixed income markets. Primary market efficiency and HNW individuals; and LE 100 million under a public offer tranche defined as the ability to tap savings expeditiously with low issuance costs offered to retail investors through bank branches and oversubscribed by are critical factors for the development of the non-government fixed income 11 times. The coupon was 12.25 percent with a 175 basis point spread market. As opposed to the manner in which government bond markets when compared with equivalent government bonds. After the revolution function, corporations need to have the ability to tap funds opportunistically in January 2011, Mobinil placed a syndicated loan for LE 2 billion, which and with a broad range of instruments depending on market conditions. This illustrates the fact that the supply and demand for funds existed but the includes the capacity to access different types of investor segments involving appropriate environment was still missing for corporate bond issuance to a more diverse range of placement schemes than contemplated in government become a reliable and regular funding channel for most corporations. bond markets. There are variations in the schemes depending on the country Public juristic bonds. Issues from public sector and economic but they can be broadly classified in three types: public offers; exempt public authorities, known as public juristic bonds, have recently come to the market offer regime10 for qualified institutional buyers (QIslamic Bankings) and since the issuance of the ministerial Decree No. 1 of 2010 authorizing public private placements.11 The role of the securities regulator is essential in three juristic entities and international financial institutions to issue bonds in the aspects: ensuring that there is a sound regulatory regime in place (issuance, debt market in Egypt. There were four issues outstanding of LE 2.5 billion creditor’s rights, corporate governance); developing a regulatory framework each (see Table 3.11). All issues belong to a single issuer, the NUCA. They flexible enough to enable the election of one of these three models; and being represented the largest size overall in the corporate bond universe. There able to process funding requests in a timely manner. were two short-term issues with maturities of 13 months and two medium- Egypt’s non-government fixed income industry is nascent and term issues with maturities of five years. The latter have floating rate coupons underdeveloped representing only 2 percent of GDP or LE 23.5 billion referenced to the 6-month T-Bill. (US $4 bn.) as of end 2010. The government bond market dominates at Revenue Bonds: along the lines of municipal bonds, EFSA introduced approximately 29 times the size of the corporate bond market compared with to the capital market law executive regulations the ability of public authorities the 2.5 equivalent ratio present in many EMEs.12 Despite an unfavorable to issue revenue bonds for commercially viable projects. To date, this newly structural environment for corporate bonds, recent regulatory reforms are introduced instrument has not been used. in part responsible for the growth in issuance value by approximately 160 Securitized bonds. There are 13 outstanding securitized issues of which percent between 2008 and end-2010. Issuance has been maintained at a two were issued in 2006 after the Ministry of Investment set the regulatory 94 Financial Development and Inclusive Growth The Development of the Capital Markets 95 framework by the issuance of the ministerial Decree No. 46 of 2004 that added Table 3.8: Structure on Securitized Issues as of December 2010 a new chapter to the executive regulations of the Capital Market Law regarding Value Number of Issuer Percent securitization and its amendment by the ministerial Decree 139 of 2006. To date outstanding issues there have been only four issuers, yet they have been able to tap the market Contact 874,196,602 14 7 on a relatively regular basis with maturities ranging from 1 to 10 years. For Al Tawfeek Securitization Company 874,062,500 7 3 example, July 2010 was a peak month with Contact Cars for Securitization and Egyptian Arab Land Bank 925,012,500 14 2 Al-Tawfeek for Financial Leasing tapping the market with three different issues Al Tamer Securitization Company 4,168,965,517 65 1 each at maturities of 1, 3 and 5 years. Issues generally have a fixed coupon, except when they extend beyond 5–year maturities, and most of them have a call option. Total 6,442,237,119 100 13 As in the corporate bond market the primary market is generally split between Source: Own elaboration with data from EGX, Yearbook. Egyptian private placements16 taking around 90 percent of the issue and public offerings restricted to retail investors taking around 10 percent of issuance. Commercial Paper. Short term paper for working capital is almost non-existent, even for the larger companies, although the 13 month issues Table 3.7: Overview of Corporate Bonds in Egypt as of December 2010 (LE) by the New Urban Communities Authorities and by two securitization Call Maturity Type of companies may be classified as commercial paper (see Table 3.8). They are Issuer Size Maturity Date Date Coupon treated under the same rules as ordinary bonds in terms of the time it takes Corporate Bonds to authorize them (e.g. 2–3 months. See details in next subsection), which has deterred their broader use. In May 2011, EFSA issued a decision to expedite Ezz Steel (2nd issue) 990,000,000 6 years Jun-10 Dec-14 Fixed the approval process for the so called short-term bonds. Although this is a International Co. for Leasing 200,000,000 5 years Jun-11 Sep-14 Fixed step in the right direction, the decision still limits pre-approval to one year and the shortest tenor to 13 months with a call option six months after Egyptian Co Mobile Services 1,500,000,000 5 years Jan-13 Jan-15 Fixed issuance. Approval is also merit based. For example, issuers need to comply with 1:1 current assets to current liability ratio. Regulations to support the GB Auto 1,000,000,000 5 years Jan-12 Dec-14 Fixed development of a commercial paper market should be strongly encouraged Orascom 1,650,000,00 5 years Jul-12 Sep-15 Fixed as a first step in developing a more active corporate bond market. This would benefit the cash management needs of issuers and investors under the Golden Pyramids Plaza 1,626,238,500 7 years Dec-09 Jun-14 Floating current uncertain market environment as well as in the long run. It would also enable a segment of the fast growing MMMF industry to diversify assets Subtotal Corporate 6,966,238,500 and offer better returns. Securitized Bonds Issuance Regulatory Framework Subtotal Securitized (13 issues) 6,442,237,119 1-10 Years Only for 9 4 floating, Since 2004, the government through the Ministry of Investment and Issues 9 fixed EFSA has been taking steps to provide a more supportive environment for Public Juristic Bonds corporate bond issues through regulatory changes. Some of these reforms may New Urban Communities Authority 2,500,000,000 13 months n.a. Apr-11 Fixed be behind the 140 percent growth in outstanding issues between 2009 and 2010 (see Table 3.12). In addition to the Securitization regulatory framework New Urban Communities Authority 2,500,000,000 13 months n.a. Jun-11 Fixed setup, a set of relevant reforms was passed in 2008 and 2010 that included elimination of the requirement for private businesses to submit an auditor’s New Urban Communities Authority 2,500,000,000 5 years n.a. Mar-15 Floating certified forecast of the company’s financial prospects contained in audited New Urban Communities Authority 2,500,000,000 5 years n.a. Jun-15 Floating financial statements for the period of the bond’s maturity by the ministerial Decree No. I of 2010; introduction of a shelf registration option but limited Subtotal Public Juristic 10,000,000,000 to one year after filing and with two weeks prior notice required to sell a portion of the shelf offering amount by the Ministerial Decree 64 of 2010. Total 23,408,475,619 These two restrictions weaken the value of shelf-registration as a one-year Source: Own elaboration with data from EGX, Yearbook. grace period may not be long enough and shorter periods may be needed between the funding decision and the ability to tap the market, particularly 96 Financial Development and Inclusive Growth The Development of the Capital Markets 97 for commercial paper. It is worthy of mention that EFSA is considering resources on their balance sheet. Additionally, they can provide capital for to propose a regulatory amendment extending the maturity to two years underwriting as well as financial expertise to support origination. On the instead of one; authorization for public sector and economic authorities other hand, banks may perceive the bond market as competing for good (Public Juristic) to issue bonds to meet their financing needs and finance quality client borrowers. In this regard, banks may feel compelled to provide infrastructure projects by the Ministerial Decree No. 1 of 2010. Authorization very competitive lending conditions to prevent their targeted corporations for International Financial Institutions such as the African Development from getting direct funding from fixed income markets. Bank, the World Bank, the International Finance Corporation,…etc. to issue In the case of Egypt, low access to credit (48.5 percent loan to deposit bonds in the domestic markets after taking the CBE’s and EFSA’s approval ratio as of end–2010) would make a strong case for the development of a fixed by the Ministerial Decree No. 1 of 2010. This authorization was incorporated income market in order to improve corporations’ access to funding. However, in the Law 123 of 2008 that amended some articles of the Capital Market Law the dominance of banks in the financial sector19 leaves little space for NBFIs to 95 of 1992.In spite of the above-mentioned changes, there remain several develop in a meaningful way, either on the origination or on the savings side. major constraints that make the issuance process prohibitively expensive, A notable anomaly in the pricing of financial assets in Egypt is that uncertain and slow. All of these features are particularly detrimental for the interest charged on bank loans is generally lower than what the same issuer development of a vibrant bond market.17 Key issues that would need to be could obtain through the issuance of fixed income instruments. This places addressed as part of a sequenced plan include the following: fixed income instruments at a distinct disadvantage that is exacerbated ϘϘ The Capital Market Law establishes that a company seeking to issue when origination costs are added. Interviewed banks explain this apparent a bond or commercial paper requires the approval of its General paradox as a result of banks competing for a limited number of creditworthy Assembly, including the yield and tenure of the instrument. Securing companies. Banks are able to offer very competitive rates given the low cost of bank loans requires no such approval. The primary market remains a their deposit base and the fact that there is structural excess liquidity in the merit-based rather than a disclosure-based regime. For example, only financial sector overall. The only incentive a bank would have to support the issues with an investment grade credit rating (BBB-) or above would issuance of fixed income bonds by its client corporations would be when the receive EFSA’s approval. If during the life of the bond the rating falls compulsory 25 percent quota on its lending portfolio to a single company has below investment grade, the outstanding bond balance (including been fulfilled (e.g. this condition was behind Mobinil’s diminished issuance principle and interest) must be fully redeemed. This stringent activities). The bank would then become an active partner in the bond obligation limits the access to high quality firms that generally issuance transaction and, in many cases; it would buy a large proportion of already have access to other funding sources. the issue and hold it to maturity. ϘϘ There is no clear differentiation between a private and a public It is still too early to assess, but the recent ban on corporations investing placement in terms of differentiated disclosure requirements or the in bank CDs may trigger structural changes in financial disintermediation in availability of an expedited issuance process for the former. These Egypt. Banks have already started to sponsor fixed income mutual funds to are features commonly found in most other markets. The difference capture former CD investors (corporations, insurance companies and pension between the two is the placement methodology and the targeted funds). This shift would imply a reduction of banks’ liability bases, which can be investors. A private placement is organized following a book-building expected to trigger their active involvement in origination transactions in fixed process involving only institutional investors, whereas public offerings income instruments for their regular corporate clients. are targeted at retail investors and allocated on a pro-rata basis. Since 2009, the government has initiated a reform plan to improve the ϘϘ Market participants perceive the offering preparation process as enabling environment for NBFIs as a means to promote the incipient financial expensive, slow and with an unpredictable approval timeline and disintermediation process in Egypt. These reforms, as well as recommendations outcome. The latter ranges from 3–5 months, according to investment to reinforce them are explained in other sections of this document. bankers interviewed, which compares unfavorably with the 25-day The role of government debt markets. Government debt as a risk- average registration or approval time present in many EMEs.18 free asset provides a reference price against which non-government fixed Structural Obstacles income instruments can be priced. A liquid yield curve in government debt including long-term maturities is therefore an essential condition precedent The Role of Banks. There is varied experience across countries with to the development of non-government fixed income markets. Additionally, respect to the constructive or unconstructive role of banks as sponsors of the latter can leverage on the market infrastructure (trading, clearing and non-government fixed income markets. As sponsors, their primary focus settlement) developed for government bond markets. may be on bond origination to fund their corporate clients, as this will free 98 Financial Development and Inclusive Growth The Development of the Capital Markets 99 The Ministry of Finance has conducted several reform initiatives since Secondary Markets 2004 to develop more liquid government debt markets. Phase II (2009–2012) of Government Fixed Income Markets. Deep and liquid secondary the reform program established a systematic issuance plan for medium and long markets of public debt help countries implement their funding strategies term benchmarks up to 10 years. This was complemented with a series of planned at lower cost and risk. They also promote efficient price discovery and the reforms in secondary market architecture, clearing and settlement and a Repo dissemination of a risk-free yield curve that supports the development of framework. By December 2010, liquidity in the secondary market had started other fixed-income products, such as corporate bonds. Well-functioning to develop and foreign investors were buying medium and long-term debt in secondary markets are a function of a country’s market architecture, sizeable volumes with holdings reaching a peak of 16 percent of outstanding debt investor’s incentives to trade and enabling conditions provided by the in October 2010.20 As of May 2014, foreigners hold LE 300.5 million in T-Bills. several building blocks covered in this report: money markets; primary Political and financial uncertainty following the revolution in 2011 markets; investor base; and clearing and settlement infrastructure. Egypt’s brought about a suspension of the government’s implementation of its strategy secondary markets are illiquid and concentrated in the short-term. Monthly as foreign capital fled the country and domestic investors shifted to short- value of T-Bond trades was following a positive trend prior to the 2011 term government paper. However, the Ministry of Finance maintained most revolution, increasing from an average of LE 1.5 bn. in 2008 to LE 5.7 bn. of its pre revolution accomplishments in terms of regularity of auctions and in the second semester of 2010. Value of T-Bond monthly trades reduced to issuance policy transparency, which consolidated T-Bills as price references levels close to LE 2 bn. and became more volatile during the 10 months that for non-government financial assets. Once the Ministry of Finance is able to followed the January 2011 revolution (including some periods of no trades resume its strategy to lengthen the government yield curve, it can be expected due to temporary shutdowns of the stock exchange). to become over time a reliable price reference for the non-government fixed Growing liquidity of T-Bonds in 2010 was being fueled by the income market. pro-active primary market strategy of the gradual building of T-Bond There has been some debate in the market over the potential crowding benchmarks, described previously. On the primary government fixed out effect on the corporate bond market of increased government issuance. income markets. Despite these developments, the average volume of While growing fiscal deficits may produce some negative consequences, it is T-Bond transactions as of December 2010 remained only a small fraction, important to evaluate them against a broader context. The capital markets approximately 10 percent, of the volume of T-Bill monthly transactions. in Egypt have historically been relatively open and under normal conditions, For example, monthly turnover of T-Bills was approximately 20 percent such as those existing before January 2011, and was able to attract foreign in the last months of 2010, compared to 2 percent for T-Bonds during the investors to hold as much as 16 percent of the government debt, which should same period. still leave sufficient space to channel savings to corporate debt. The latter A significant agenda of reforms to enhance secondary market liquidity, also has the advantage of being tax exempt. especially of long-term securities, was in the process of implementation when One factor that would seem to have a more significant negative impact the revolution arose. The agenda combined reforms in all of the building on the issuance of corporate bonds is the high reported inflation that results blocks for bond market development, as described in other sections of this in high yields on both government and corporate bonds. Additionally, report, and specific measures to (i) enhance the efficiency of Egypt’s secondary spreads on corporate debt are even higher when compared to bank loans. market architecture, including the removal of critical bottlenecks; and (ii) This can be explained by the fact that excess liquidity conditions and the building an enabling infrastructure with appropriate incentives for improved existence of only a few creditworthy corporations prompt banks to offer very price dissemination and trading. low interest loans. Egypt’s market architecture is segmented between T-Bills and T-Bonds by reporting, trading and settlement arrangements.22 Other critical Enabling Environment21 bottlenecks include: Credit rating agencies. Fixed income issues in Egypt require a credit ϘϘ A “de facto” monopoly of PDs in T- Bond secondary market trades - PDs rating prior to issuance and updated on an annual basis after issuance. The are the only ones entitled to meet the mandatory reporting requirements minimum accepted rating is investment grade. to EGX; and Taxation framework. The taxation framework is very favorable as ϘϘ Pre-deposit of T-Bonds before trades are matched and the inability corporate bonds are tax-exempt whereas government securities have a 20 to sell a T-Bond until it is settled on T+ 1 MCDR; that in practice percent withholding tax. This is compared to other financial assets that are prevents intraday trading and short selling, with severe adverse also tax exempt such as mutual funds, saving and time deposits, capital gains implications for secondary market liquidity and market making. and dividends on stocks. 100 Financial Development and Inclusive Growth The Development of the Capital Markets 101 Figure 3.5: Government Bonds Trading Volume, Jan 08 – Oct 11 ϘϘ Improved price dissemination and transparency will also depend on Government Bonds Trading Volume (EGP Bn) strengthening mechanisms to collect pre-trade prices (e.g. aggregate 9.00 measures derived from quotes in electronic trading platforms), and 8.00 Trading Volume (EGP Bn) 8.13 post-trade reporting obligations. Altogether these measures will not only enhance the conditions for the creation of a reliable risk-free 7.00 6.11 yield curve, but will also allow wider enforcement of mark-to-market 6.08 6.00 5.54 5.48 5.92 5.91 valuations by the securities regulator for investors’ portfolios in 5.00 5.04 4.70 accordance with the requirements of the accounting regime. 4.38 4.31 4.00 3.72 3.93 4.07 3.81 4.14 Non- government fixed income markets. Secondary markets in 3.00 3.28 3.29 2.86 3.41 2.97 3.21 3.09 2.97 2.89 corporate bonds are generally thin even in Advanced Economies (AEs) with 2.71 2.78 2.75 2.27 2.40 2.56 2.34 large corporate bond markets. This is the result of the nature of corporate 2.00 1.84 1.32 bond funding: it is opportunistic; does not always use standard instruments; 1.14 1.00 0.78 0.65 0.46 0.71 0.97 0.43 0.77 0.69 and issues are generally too small to be liquid. Thus, corporate bond markets 0.30 0.00 are generally a universe of small fragmented issues with higher yields but low liquidity when compared to government bond markets. Low liquidity is Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08 Oct 08 Nov 08 Dec 08 Jan 09 Feb 09 Mar 09 Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 reinforced by the dominant role of institutional investors with buy-and-hold Source: CBE. investment strategies as long as high yields can be obtained. However, the Improved market architecture should include measures to harmonize ability to trade options both OTC and through electronic trading platforms procedures for clearing and settlement of T-Bills and T-Bonds, even if conducted is still a relevant feature in corporate bond markets. EMEs generally tend to by two different institutions, CBE and MCDR (as discussed in more detail in have even thinner secondary markets caused by a smaller size both overall section 5 on Clearing and Settlement). It should also include the removal of and at the individual issue level. Also, their generally weaker infrastructure impediments to broader access of a variety of investors to the secondary markets for price dissemination, trading and clearing and settlement contribute to of T-Bonds. Non- PD institutions should be allowed to trade among themselves anemic secondary markets. without the obligation of having to trade (or register trades) via PDs. Despite the fact that 2010 represented a peak year in Egypt (Figure An overhaul in the infrastructure for trading and in incentives for price 3.7), the secondary market for corporate bonds remained particularly thin dissemination is needed to complement the suggested changes in market at approximately USD 100 million or less than a 1.4 percent turnover ratio architecture. A roadmap of reforms in this regard includes: as of end December 2010. All trades take place on the EGX as the Capital Market Law extends the tax exemption to listed corporate bonds only. Hence, ϘϘ Designation of an official electronic trading platform and the creation all corporations issuing bonds in the local market opt for listing the bonds of a securities lending facility for PDs: these two platforms would issuance with the EGX and corporate bonds may be traded through the main provide the foundations for greater price transparency of T-Bills and trading system at EGX that is open for four hours daily. T-Bonds. The electronic trading platform should ideally include a B2B segment as well as allow B2C trades. The securities lending Low secondary market volumes can be attributed to the small size of facility, managed by Ministry of Finance and dedicated to PDs would the market, the fact that some issues are held by very few investors (banks be a powerful tool to mitigate resistance of the PDs to comply with and State Owned Enterprises), and the requirement of trading through the quoting obligations. EGX facilities. Although the structural reasons (e.g. market size, investor base) are significant factors contributing to the scant secondary market, ϘϘ Introduction of a new PDs code of duties, including quoting it might also be relevant for the authorities to consider providing greater obligations: enhanced infrastructure for trading will provide the pre- flexibility in utilizing various secondary market alternatives, such as the conditions for Ministry of Finance to monitor and enforce quoting availability of a pure OTC market. Under this scheme, EGX could continue obligations of PDs. Procedures for firm bid and ask spreads for key to bear price dissemination responsibilities and the attendant revenue that benchmark securities should be introduced and followed by PDs, might be generated therefrom. observing minimal amounts, maximum spreads and pre-defined trading periods. A broader revision of the PDs code of duties should Investor base. A large and diversified investor base is important for be conducted to ensure a balanced set of incentives and obligations ensuring high liquidity and stable demand in the government fixed income that would enhance their performance. markets. Development of contractual savings institutions such as pension funds, insurance companies as well as mutual funds, is an extremely important 102 Financial Development and Inclusive Growth The Development of the Capital Markets 103 component since it is these entities that serve to contribute to the creation holdings of banks and the fact that 15 of the banks are also PDs, volumes in of a natural market for medium and longer-term government debt. Foreign the secondary market are extremely low (Table 3.13). As mentioned in the investors have also been major drivers in lengthening the yield curve and sections on money markets and government fixed income markets, structural supporting secondary market liquidity across most EMEs. A heterogeneous changes on several fronts would be needed to invigorate the secondary investor base with different time horizons, risk preferences, and trading market. These include more effective management of excess liquidity, reform strategies ensures active trading and consequent high liquidity and, enables of the secondary market architecture and PD rules, changes in the eligibility the government to execute its funding strategy under a wide range of market of T-Bonds for the liquidity ratio and a robust repo framework. conditions. Efforts should be made to ensure equitable treatment of investors in accessing government debt markets. Table 3.9: Structure of Banks’ Securities Portfolios Expressed as a Percentage In the case of non-government fixed income markets, a stable and 2009 2010 broad institutional investor base is one of the pillars of a vibrant market as T-bills 58.1 43 banks and retail investors are unlikely to be relevant investors. Corporate T-bonds 24.9 35.6 bonds compete with bank lending and require a degree of sophistication Corporate Bonds 2.2 1.9 generally absent among retail investors. Low liquidity is also a deterrent. Equities 10 8.2 Corporate bonds are ideal assets for pension funds and insurance companies Foreign Securities 4.8 11.3 to match against their long-term liabilities. In this sense, most EMEs with Total 100 100 bank dominated financial sectors face a structural obstacle to developing Source: CBE Annual Report. corporate bond markets on the demand side. Generally, those EMEs that have a more diversified institutional investor base, even if it is at an early Inadequate accounting rules may also serve as a disincentive to trading. stage of development, have proven most successful in developing deep and Accounting standards for Egyptian banks are very similar to IFRS. However, liquid corporate bond markets (e.g. Malaysia, Korea, Brazil, South Africa) the enforcement of the accounting rules for financial instruments is unclear. In Egypt, the poor development of institutional investors and the Informal comments made by interviewed market participants suggest that fact that those that do exist are concentrated, mainly in SOE’s, represents the differences between “trading”, “available for sale” and “held-to-maturity” one of the structural reasons underlying thin trading in the government portfolios are merely notional. Moreover, T-Bills are not marked to market bond market and the small size of the corporate bond market. NBFI assets irrespective of the portfolio to which they belong. amounted to approximately 8 percent of GDP compared to roughly 106 percent Table 3.10: Distribution of T-Bond Holders as of March 31, 2008 for banks as of December 2010. Concentration is high within all segments and SOE’s, particularly in the insurance area, have the largest asset size. Type of investor LE million Percent In addition, banks dominance as fixed income investors (35 percent of their Banks 40.742 55.43 assets) has been a major obstacle for the growth of NBFIs. However, there government and Social Insurance Fund 14.840 20.19 are several promising changes currently underway related to banks’ interest National Investment Bank 7.819 10.64 in sponsoring mutual funds that could leverage ongoing efforts to support Insurance companies 3.397 4.62 government and non-government fixed income markets both on the supply Foreign Investors 2.848 3.87 and the demand side. Holding companies 2.061 2.80 Banks. The 39 commercial banks operating in Egypt are the main Others 0.666 0.91 investors in government securities with holdings of approximately 55 percent Insurance Funds 0.361 0.49 of total T-Bonds as of end–2010, representing 35 percent of their total assets Funds & portfolio management companies 0.757 1.03 (Table 3.9). This is a result of banks’ dominance in the financial sector, Individuals 0.100 0.01 excess liquidity, a high liquidity ratio, (20 percent of deposits that can be Total 73.500 100.0 fully met by holding government securities) and the low level of credit to the Source: Ministry of Finance. private sector, which amounts to only around 48 percent of banks’ deposits. Banks also represent the main investors in non-government fixed income Mutual funds are the main institutional investor and MMMFs instruments. Nevertheless, given the smaller size of this market, it still represent 92 percent of AUM (Table 3.14). All MMMFs are sponsored by banks represents only 1.9 percent of their securities portfolios versus 79 percent and started to gain prominence in 2005 when the CBE was offering high yields for government securities (Table 3.9). Despite the high government debt through the deposit corridor facility that banks were intermediating to their 104 Financial Development and Inclusive Growth The Development of the Capital Markets 105 corporate and HNW clients through those MMMFs. The nature of MMMFs was No. 126 of 2008 to reduce the average maturity of the MMMFs investments distorted as they held a large proportion of their assets in bank deposits (e.g. while setting a maximum maturity for the MMMF investment of thirteen 40 percent as of end–2010). But after the revolution, volumes of T-bill issuance months. During 2009 and 2010, EFSA initiated a review of select mutual fund at high yields increased bringing MMMFs’ holdings of bank deposits down to regulations aimed mainly at addressing conflicts of interest. Recently, EFSA 8 percent of AUM. The high growth rates of MMMFs since 2005 illustrate the issued a series of Capital Market Law Executive Regulations including a code potential for dis-intermediating savings in Egypt, provided that banks have of conduct, the separation of directors for bank-sponsored funds and related the right incentives to support such a strategy. As of December 2010 there party investments,23 and the appointment of Independent Fund Administration were 79 investment funds compared to only 49 in December 2008. Companies to protect investors by performing critical back office functions. As of May 2014 Money market funds represent 88.5% from total funds. In 2014 the regulation for Mutual Funds was overhauled by EFSA, Fixed income and equity funds currently represent around 8.5% of total introducing numerous international best practices and activating real estate mutual funds, not much changed from 8% stated above. investment funds. Specific rules for fixed income and money market funds were stipulated, in addition to introducing for the first time exchange traded Table 3.11: Evolution of Mutual Funds (LE Million) index based funds (ETFs). EFSA also set an end of August 2014 deadline Dec-09 Percent Dec-10 Percent May-11 Percent for all funds to appoint a fund administration services company to value the Money Market Funds 50,130 89.7 51,345 91.2 57,337 88.6 certificates and maintain certificate holders registry, Additional duties were assigned for the fund administration services companies handling real estate Other Funds 5740 10.3 4,925 8.8 7,390 11.4 investment funds (with regards to ownership titles, property contracts and Total 55,1870 100.0 56,270 100.0 64,729 100.0 property valuation reports). Source: Own elaboration with data from CBE. Despite that the current regulatory framework governing mutual funds in general equally allows banks and insurance companies to sponsor and Table 3.12: Holdings of Money Market Mutual Funds (LE Million) promote funds without establishing a separate fund company, it was banks Dec-10 Percent May-11 that took advantage of such regulation and extensively promoted MMMFs. If insurance companies follow banks footsteps, money market mutual funds T-Bonds 1,209 2.4 919.483 could become the base for the development of a broader family of mutual Corporate Bonds 1,164 2.3 121.006 funds in longer-term instruments. In the short term, MMMFs could also T-Bills 28,038 54.6 50,692.96 generate demand for commercial paper and become active participants in the Deposits 20,346 39.6 4,664.474 repo and secondary markets. Mutual Funds 558 1.1 It is worth noting that EFSA issued in early 2014–for the first time– Other 30 0.1 939.432 regulation addressing the requirements and financial adequacy conditions related to approving the issuance of funds by insurance companies. Total 51,345 100.0 57,337 Source: Own elaboration with data from CBE. Policies supporting mutual funds would need to combine regulatory upgrades to facilitate access to independent asset managers, as well as As of end-2010 several new fixed income funds focusing on investing in actions to increase the supply of instruments and their secondary market corporate bonds were about to be launched but were postponed with the onset liquidity in both government and non-government fixed income markets. of the revolution. Banks new found interest in sponsoring fixed income mutual This is in line with several initiatives that the government had initiated prior funds resulted from a CBE regulation prohibiting corporations, including to the revolution (see sections above on primary and secondary government pension funds and insurance companies, from investing in bank CDs. Fixed fixed income markets). income mutual funds would enable banks to retain their former CD corporate Insurance companies. The life insurance sector is small with AUM investors while offering higher returns than the existing MMMFs. The NBE of LE 38 billion as of June 2013. The insurance sector has undergone a series took up the initiative by launching a LE 200 million fixed income mutual fund of structural reforms. While these reforms are serving to encourage the in September 2011. As the market stabilizes, it can be expected that other sector to become profitable and operate on a fully commercial basis, it is a banks will follow a similar strategy. It is worthy of mention that the growth slow process that will not make insurance companies a relevant investor in of MMMFs would not have been possible unless for the Ministerial Decree the short term. Most of the sector’s assets are invested in bank deposits or No. 209 of 2007 issued by the Minister of Investment that set the regulatory government debt and are not currently a relevant source of demand for non- framework for MMMFs. This Decree was further amended by the Decree government fixed income instruments. 106 Financial Development and Inclusive Growth The Development of the Capital Markets 107 Table 3.13: Assets Under Management (LE Billion) Figure 3.6: Evolution of Foreign Investor Holdings of Domestic Debt in Percentage Institutional investor AUM Percent Mutual funds 65.7 53 Foreign investor holdings of domestic debt (%) Insurance (Life reserves) 23.1 18 Pension funds 36.1 29 21.3% Total 124.9 100 Source: Data for Insurance and pension funds is as of June 2010, and for mutual funds it is as 15.8% of December 2010. Pension funds are small contributors to the development of the fixed income market with AUM around LE 39.4 billion or 2.3 percent of GDP as 7.8% at June 2013. They are not always professionally managed, and a large 6.0% proportion of the private ones operate with actuarial deficits.24 Currently 2.8% they are not relevant contributors to the non-government fixed income market as approximately 75.5 percent of assets are invested in bank deposits or government debt. Aug 2008 Dec 2008 Aug 2009 Oct 2010 Feb 2011 There are a series of ongoing or planned reforms that are essential for Source: Ministry of Finance. the sector to develop on more solid ground; however, it cannot be expected to become an important investor in the short term.25 The sale of T-Bills to foreigners has been a relevant line of business for some banks. They receive either the Ministry of Finance commission for Foreign Investors primary market placements to clients or they charge a spread of around The evolution of foreign investor holdings in Egypt’s government fixed 50–60 basis points over primary market prices if they sell securities from income instruments shows the potential that can be achieved in attracting their portfolio. Once the political situation stabilizes, if Ministry of Finance foreign capital when the political situation stabilizes. Before Egypt initiated resumes its strategy to lengthen the yield curve a more important presence a systematic strategy to lengthen the yield curve in 2009, foreign investors of non-residents in the medium and long term debt segment can be expected. were mainly interested in T-bills, given the low liquidity in T-bonds. Non- In this context, reform in upgrading the secondary market architecture, resident holdings in T-bills increased from 10 percent in 2006 to 50 percent in enhanced price transparency and more robust clearing and settlement March 2008 whereas investments in T-bonds were almost non-existent. After infrastructure would be essential to accommodate and reduce the volatility the achievements of the T-bond issuance strategy in 2009, non-residents of foreign investors’ demand. investors were starting to purchase T-bonds for the first time after having been exposed to T-bills exclusively. Clearing and Settlement Infrastructure Overall foreign holdings of government debt have experienced large The clearing and settlement infrastructure should effectively swings depending on international perceptions of EMEs during the financial compromise between the business interests of different market participants crisis and, later, with increased risk perceptions after the revolution. In and support planned market development policies. Access should be granted August 2008 a peak was reached with non-residents holding 21.3 percent of on equivalent terms to banks and NBFIs to ensure a level playing field in tradable domestic debt (DD), which dropped to 6 percent in December 2008 the securities markets. Systems should be cost effective, efficient and have and to a low of 2.8 percent a year later in December 2009. After that non- the capacity to manage risk and limit exposure to systemic risk. Given residents regained confidence reaching another peak holding of 16 percent its relevance for the financial sector, it is essential that the institutional in October 2010, which dropped to 7.8 percent in February 2011 after the structure is neutral and with a strong supervision and oversight role of the revolution (Figure 3.6). public sector. Supervisory responsibilities are normally conducted by the securities regulators, whereas oversight, more related to systemic risk and policies, is generally the responsibility of the Central Bank. Ownership and governance structures can follow different models depending on the country ranging from public sector to private sector ownership or hybrid models. 108 Financial Development and Inclusive Growth The Development of the Capital Markets 109 Institutional Organization fixed income instruments still at a developing stage, the involvement of the CBE In Egypt clearing and settlement arrangements are split by law between and the Ministry of Finance in the design of services and operations of clearing two CSDs, both operating fully dematerialized regimes: CBE’s bookkeeping- and settlement of government debt is essential to support planned policies. Given entry system for T-bills and MCDR for T-bonds, non-government fixed income the current CSD structure two models are proposed that are variations of the instruments and equities. MCDR is a self-regulatory organization (SRO) dual CSD structure. supervised by EFSA and owned by the EGX (5 percent), banks (50 percent) and Under the first proposed model, the current institutional segmentation securities intermediaries (45 percent). Only banks can access the CBE’s platform, between the CBE for T-bills and the MCDRfor T-bonds and non-government whereas all financial intermediaries (banks, investment banks and brokers) may securities is maintained. However, settlement services and procedures have direct accounts at MCDR. for T-bills and T-bonds would need to be harmonized and upgraded (see There are two models that represent the most widespread infrastructure suggestions below) so that the infrastructure does not segment the T-bill arrangements across both EMEs and AEs. The first one is split between a single and T-bond market. In addition, it is recommended that the CBE holds a CSD for all government securities, generally operated by the Central Bank, and sub-custody account for T-bonds at MCDR so that it can process settlement a private CSD for non-government securities under strong oversight from the instructions from OTC markets. Central Bank or the securities regulator. The second model is a single CSD for all Figure 3.8: Proposed Model 1: T-Bills and T-Bonds under CBE securities that in some cases is partially owned by the public sector.26 Figure 3.7: Central Depositary: Existing Model for T-Bills and T-Bonds Central Depository for Central Depository for T-Bonds, T-Bills Non-government Bonds, Central Depository for Central Depository for T-Bonds, and Equities T-Bills Non-government Bonds, and Equities Banks Banks Investment Brokers Banks Banks Banks Investment Brokers Banks Under the second proposed model, government fixed income instruments are consolidated under a single CSD owned and operated by the CBE, whereas There are substantial gains in economies of scale under the single CSD non-government securities continue to be registered and settled by MCDR. This model but there are also policy reasons supporting the dual model approach, model better reflects the desired unified plan for all government fixed income particularly in the early stages of government debt market development. A CSD securities but may involve more complex institutional changes than model. for a wholesale government debt market requires a strategic vision and financial A Common element under both models is that direct accounts in the and operational resources that may not be available in the private sector in the CSD are not restricted to banks. This is an important feature to support early stages of market development. In addition, central banks and Ministry competition and a level playing field in the fixed income market. If only banks of Finances are generally better placed to understand the policy challenges to can access the government debt CSD they will be in a position to prevent develop efficient government fixed income markets. The lack of the right clearing investment banks and intermediaries from competing and providing trading infrastructure may undermine implementation of those policies that are critical services to their market segments. It is important that they have direct access for the financial sector overall. As an example, the dual model split between to securities accounts even if they use a settlement bank for the cash leg of government and non-government securities was followed in most European the transaction. In both models it is proposed to provide direct access to CSD countries until the adoption of the Euro. In the case of Egypt, with government securities accounts to both investment banks and brokers. 110 Financial Development and Inclusive Growth The Development of the Capital Markets 111 Services and Operations flexible settlement cycles, including the option to settle on T as is the case for T-bills. Figure 3.9: Proposed Model 2: Connectivity between CBE and MCDR ϘϘ Repos cannot be reported and settled as distinct operations, so they are processed as two separate outright purchases. The second leg of Central Depository for the repo is submitted and processed on settlement due date, thus Central Depository for T-Bonds, leaving an unreported settlement exposure between the two parties T-Bills Non-government Bonds, of the repo. As the repo framework is developed, the clearing and and Equities settlement platforms should be enhanced to support standard repo settlement services: e.g. reporting of both repo legs on trade date, automatic settlement of the second leg, rollover and early settlement facilities and collateral management. ϘϘ The DVP principle is not fully complied with, but there is an implicit guarantee that the CBE will always settle the cash-leg by providing a lending facility to the settlement bank if it has insufficient funds. Investment This arrangement is expected to eventually evolve into a standard Banks Banks Brokers Banks DVP model 2.27 This would imply a major change for the MCDR in terms of its responsibility for managing the settlement risk of the cash leg. It is not clear at this stage whether this would be addressed by the un-winding of the net in order to subtract a defaulting trade Although the CBE bookkeeping system for T-bills settles on T and or through the creation of a guarantee fund. presents a low degree of automation, there are plans to develop a state-of-the- art central depository in line with the existing RTGS system operating since ϘϘ Settlement for non-government fixed income instruments and equities 2008. The intraday liquidity facilities developed for the RTGS system would generally takes place on T+2, although authorized brokers may do require a fully automated central securities depository (CSD). Currently intraday settlement of eligible actively traded securities which are the system is not fully compliant with the delivery versus payment (DVP) included on a list and selected based on liquidity criteria. Risk of non- principle but risk is limited as only banks with reserve accounts are members delivery is managed by blocking securities before trading, whereas non- of the CSD and they cannot access their securities accounts on-line. payment risk is addressed through a guarantee fund. There are plans to implement a securities lending facility to address non-deliveries MCDR facilities for T-Bonds settle on T+1 and present a higher degree and eventually eliminate the pre-trade blocking of securities. Non- of automation than at the CBE’s system. However, there are several problems listed physical securities can also be settled following a T+4 cycle that in the settlement arrangement that would need to be addressed in order to is bilateral and outside the formal settlement mechanism. support a liquid and efficient government fixed income market: ϘϘ T-bonds are blocked in the seller’s account before trading, which prevents intraday trading or short-selling which is a condition Concluding Remarks precedent to introducing a market-making program. There are plans Capital markets in Egypt have gone through important reforms during to solve this conundrum in the future by implementing a securities the past decade in two phases (2004–2008 and 2009–2012) with differing results. lending facility that would address the risk of non-delivery. Government debt markets achieved positive progress while non-government fixed ϘϘ The cash leg of T-bonds is settled on a multilateral net basis with income markets, in spite of commendable changes, are still facing a challenging equities and corporate bonds. Going forward settlement cycles of those agenda to become a relevant funding channel to private business. This is the instruments should be segmented as they bear different types of risk. right sequence to develop capital markets. Focus on government debt markets, ϘϘ Settlement of T-bonds can only be conducted with instructions from as seen in other countries, is the first step to increasing financial sector efficiency the EGX PD trading system and is limited to a single settlement cycle overall and to creating the first building block for robust capital markets. on T+1. When planning the development of a true OTC government Efficient government debt markets lower funding costs of public deficits, support fixed income market (see details in section on government fixed more effective monetary policy, provide price references for private bonds and income secondary markets), it will be important to enable processing equity valuations, contribute to developing risk management tools for financial of OTC generated settlement instructions, as well as introduce more institutions, and support sustainable integration with global financial markets. 112 Financial Development and Inclusive Growth The Development of the Capital Markets 113 Equity and non-government fixed income markets are an alternative financing Endnotes channel to banks that can broaden access to capital and lower costs to the private 1 This background paper was elaborated by Catiana García-Kilroy and Anderson Caputo Silva. The authors would like to thank Patrick Conroy for reviewing the document and providing valuable comments, and Olga sector, SOEs and local governments. Akcadag and Indhu Raghavan for their excellent research support. The views expressed in this document Reforms in Egypt’s government debt markets included the standardization are those of the authors and do not necessarily represent the views of the World Bank. 2 Auctioned repos with T-Bills as collateral were introduced in April 2011 to address eventual liquidity of issued debt, the development of predictable benchmarks through competitive shortages caused by financial stress during the revolution. auctions, and the extension of the yield curve up to 10 years. A solid design of 3 It can be defined as two standing facilities: the overnight lending and the overnight deposit facility with the secondary market and its supporting clearing and settlement infrastructure their respective interest rates established by the Monetary Policy Committee. was also addressed. In the non-government fixed income market, several legal 4 See more details in background paper Herrera S. (February 2011): Macroeconomic Stability and Financial Sector Development. reforms were enacted including simplified requirements for registration, and the 5 Effective sterilization of excess liquidity requires issuance of long-term liabilities, which may compete with broadening of instruments such as securitized vehicles, international financial T-bonds. Several countries have implemented overfunding schemes through which Ministry of Finance institutions (IFIs), and public juristic bonds. Equity markets increased their size sterilizes on behalf of the Central Bank with its own instruments. 6 The term Repo as used in this document is generic and refers to either documented repurchase agreements mainly through privatizations and benefited from an active program in EGX to or documented sell-buy backs. increase efficiency in the primary and secondary market. Attention was also placed 7 Standard securities are tradable T-bills and T-bonds placed under competitive auctions, while non-standard in expanding access to smaller companies through the Nilex board. On the demand securities reflect non-tradable Government debt placed under non-market schemes. side, a nascent mutual fund industry was supported starting with money market 8 Greater price discovery and reduced cost was shown in the first re-opening of the 3-year bond launched in January 2009. Dispersion of winning bids (spread between maximum and minimum winning bid yields) mutual funds, followed by fixed income funds. Finally, the merger of all regulatory dropped from 0.45 percent to 0.16 percent, while the average yield reduced by approximately 130 bps. This bodies under EFSA was an important step to better articulate supervision and strategy also facilitated the launch of a 5-year bond with low dispersion of winning bids 0.18 percent, a significant evidence of price discovery. development policies. All these changes were slowed down or put on hold after the 9 This index includes 15 benchmark bonds. revolution. While no reversals have been seen so far, it would be essential to resume 10 This is a hybrid scheme reflecting features of both public and private offering regimes. See more details in planned reforms to continue the momentum achieved prior to the revolution. IOSCO Development of Corporate Bond Markets in the Emerging Markets, November 2011. 11 The different features of corporate bond markets when compared to Government bond markets include Capital markets in Egypt are confronted by challenges of both structural the smaller size and the unpredictability of their funding needs. Therefore, their inability to create market and institutional natures. Structural issues include the need to a return to political benchmarks, which characterize the more standardized and predictable issuance policies employed by Governments. and macroeconomic stability, which would enable issuers and investors to plan 12 See IOSCO 2011. longer-term investment strategies. A more stable environment would still need 13 Public juristic entities are defined as public sector and economic authorities. to address broader financial sector reforms, including the impact of a dominant 14 Orascom Construction, Mobinil, Ezz Steel. GB Auto. Golden Pyramids and International Co Leasing. banking sector that has been detrimental to capital market development. 15 Private placements in Egypt require filing with EFSA and the delivery of a conforming prospectus. They also need to be listed and traded in the Exchange market as any other publicly offered bond issue. The main From an institutional perspective, the most important step would be difference with public offers is that they are only offered to institutions through a book-building process to resume government debt market reforms, as this will create an enabling instead of a public offering with a pro-rata allocation process. environment for non-government fixed income and equity market development. The 16 See footnote 14 above on private placements. two latter markets would require the development of an EFSA led reform plan in 17 Cost of issuance is around 3 percent of issued volume according to OECD, 2010, while mature markets such as the US and Japan present cost of issuance between 1 and 2.5 percent. coordination with other government agencies (CBE and Ministry of Finance) and 18 See more details in IOSCO Development of Corporate Bond Markets in the Emerging Markers, November the private sector. On non-government fixed income markets, a new regulatory 2011 p14. framework should be designed to increase issuance efficiency, including a less 19 Bank assets amount to 106 percent of GDP whereas NBFIs amount to only 8 percent. costly institutionally oriented market segment, as employed in other markets. On 20 See details in background note on Government debt markets. the equity market, besides resumption of EGX efforts to increase secondary market 21 For details on corporate governance, accounting and creditor’s rights protections see background note by Jonathan Katz: non-bank financial services regulation in Egypt. efficiency, the State could play an important role in increasing the free float of its 22 The T-Bill market is OTC and settles in the CBE bookkeeping entry system. T-Bonds are mainly negotiated listed companies, and eventually listing suitable candidates for privatization (e.g. OTC with trades reported to the EGX system and settled by MCDRMCDR. state-owned insurers). It would be essential to clarify the status of past privatizations 23 See more details in DPL III Aide Memoire. in terms of protecting bona fide investors from rescinding concluded transactions. 24 See more details in MENA Flagship, World Bank, 2010. 25 See more details in Insurance and Pensions background note. Additionally, greater attention should be placed in reinforcing venture capital 26 For example, in Spain the Central Bank transferred the Government debt CSD to the private CSD in and private equity business that could use the exchange as a refinancing outlet. exchange for a 40 percent holding in the private CSD. Finally, creating a supportive regulatory framework for the development of non- 27 Transfer instructions for securities are settled with finality on a trade-by trade basis, with fund transfer bank related mutual funds would support both government and non-government instructions settling on a net basis with finality only at the end of the funds processing cycle. securities markets. Reforms in other NBFIs, as discussed in the next chapter would also be necessary to support a greater diversity of issuers and investors. 114 Financial Development and Inclusive Growth Non-Bank Financial Institutions 115 4. Non-Bank Financial Institutions Background The non-bank sector in Egypt was characterized by underdeveloped bond, insurance, and mortgage markets, thin trading in equities, weak corporate governance, and poor financial infrastructure. Egypt’s financial system was, and still is, mainly bank-based, with banks constituting over 95 percent of the financial system’s assets—accordingly the contribution to growth by the non-bank sector has to date been de minimis. Overall, Egypt’s non-bank sector was very small and underdeveloped before the launch of the reform programs. Insurance and Pensions The insurance sector can play a critical role in financial and economic development. By introducing risk pooling and mitigating the impact of large losses, the sector reduces the amount of capital that would otherwise be needed to cover such losses, encouraging additional investment, output, innovation, and competition. By introducing risk-based pricing for insurance protection, the sector can change the behavior of economic agents, contributing to the prevention of accidents, improved health outcomes, and higher efficiency gains. As financial intermediaries with long investment horizons, life insurance companies and pension funds can contribute to the provision of long-term finance and effective risk management. Insurers can also improve the efficiency of other segments of the financial system, such as banking and bond markets, by enhancing the value of collateral through property 116 Financial Development and Inclusive Growth Non-Bank Financial Institutions 117 insurance and reducing losses. The insurance and contractual savings its prices. Supporting infrastructure is now in place including a strengthened sector also performs an increasingly important role in helping governments actuarial profession and a more professional and market focused supervisor. create fiscal space for infrastructure investment by enabling a more efficient and equitable targeting of social insurance expenditures. These services Reform Since 2004 include the provision of supplementary health benefits, supplementary These reforms focused on financial and strategic diagnoses of the retirement incomes, natural disasters funding and the direct provision of government-owned institutions, restructuring them as necessary and risk management services to the working poor through micro-insurance. developing the necessary supporting infrastructure and institutions. As the program unfolded, it became evident that social pressures were growing and Insurance and Pensions Prior to 2004 that the general public was not benefiting in the short term from the reform Restructuring the state owned insurance sector and improved program. Thus, a second generation of reforms became necessary. Beginning supervisory capacity were the cornerstones of the reforms launched in 2004. in 2009, these reforms have focused primarily on improving the reach of the The insurance sector was facing major challenges, the National Insurance financial sector and on better integrating the insurance and private pension Company was heavily insolvent and Al Chark for Insurance was on the verge sectors with social insurance reform. of being unable to meet its obligations to policyholders and, in fact, was unable Phase I (2004–2008) largely focused on building the reform scaffolding to accurately identify its liabilities. Egypt Re, the state owned re-insurance which included carrying out an owner’s due diligence and financial diagnosis company was found to be solvent but suffering from poorly priced business of the state-owned insurers and an independent valuation of MTPL placed by the state owned direct insurers and was not able to operate on a outstanding claims provisions in the state-owned insurers and ensure fully commercial basis. Only Misr, the largest SOI, appeared to be relatively transfer of the relevant technology to the Egyptian actuarial profession (so healthy and to have adequate management and systems. that provisions could be maintained at adequate levels in the future and The mandatory MTPL insurance (MTPL or ‘ACT’ insurance) business actuarially adequate premium rates established). Reforms also included the was highly unprofitable and underpriced. The private sector insurers had setting up of an overriding governance structure for the four state-owned been avoiding this class and the state-owned insurers, which wrote virtually insurers, and the development of a supervisory development plan (SDP) all MTPL, were accumulating large losses. Increasingly, these losses were for Egyptian Insurance Supervisory Authority (EISA). After relevant legal being disguised as understated claims provisions in their balance sheets. In requirements were satisfied in mid-2006, the four state-owned insurers were addition, some group life pension insurance business sold by the state insurers placed under a holding company (the Insurance Holding Company or IHC), was providing unsustainable guaranteed rates of return and that certain life which became operational in October 2006. insurance policyholder liabilities were being valued incorrectly, leading to an Despite these reforms, the insurance sector was still facing major understatement of policy mathematical reserves. In consequence, the reform problems. There was a deficit of approximately LE3.6 billion in 2007 arising program needed to put MTPL onto a sound footing and strengthen the technical from MTPL (‘ACT’ insurance) outstanding claims provision shortfalls and capacity of the supervisor. There was also a need to strengthen the supporting overvalued property.1 In addition, there was a significant deficit in National’s infrastructure, including developing local actuarial skills and capacity, and life mathematical reserves, partly reflecting mispriced group life retirement identifying management for the state-owned insurers capable of operating in products developed for the ‘Classified Sectors’. The situation was exacerbated the new environment supported by an appropriate governance structure. by an incorrect application of methodologies for determining life insurance The private pension sector was also experiencing unprofessional mathematical reserves (in effect the application of a net premium methodology management and a number of plans appeared to be heavily underfunded. with some gross premium assumptions — effectively putting some product Actions taken to date have been largely of a diagnostic nature, although a funding on a partial PAYGO basis). Consequently, it became clear that in draft law has been produced to enable the supervisor to effectively do its job their present states none of the state-owned insurers could be privatized or and to require the appointment of professional fund managers but has not even partially privatized through an IPO. National was heavily insolvent and yet been presented to and ratified by the legislative bodies due to the non- Al Chark was on the verge of insolvency and losing money. Egypt Re., while existence of a legislative body in Egypt since January 2011. As a result of the well capitalized, was becoming a dumping ground for unprofitable business reforms state-owned insurers were able to weather the credit crisis of 2007/8. written by the state-owned insurers under pressure from significant mutual The state-owned insurers are also now better placed to compete actively in the price competition and was not servicing its capital base. market place without resorting to mutually destructive price competition. In In December 2007, Al Chark and Egypt Re. were merged into Misr, addition, private sector insurers have entered the MTPL market, which in the the strongest of the state-owned insurers and the only one with adequate past was the main source of SOI balance sheet deterioration after increasing information systems.2 A multiyear program to recapitalize the balance 118 Financial Development and Inclusive Growth Non-Bank Financial Institutions 119 sheets of Misr and National was also produced and approved. A real estate investment skills saw more than 90 percent of funds going into bank deposits management company was established by IHC to take over most of the SOI and government paper (despite an almost universal DB structure which property portfolio enabling the insurers to concentrate more on their core requires longer term investments for proper matching). In at least one case, businesses. The company’s initial task was to divest properties that did not assets were being used to fund the employer’s activities. It was also evident meet the IHC group’s strategic objectives. that many funds were likely to be seriously underfunded. Phase I (2004–2008) of the reform plan led to an improvement in the Table 4.1: Performance Ratio of the Insurance Sector (2004-2011) performance of the insurance sector in terms of real aggregate balance sheet (percent unless otherwise specified) strength and an increasing private presence. While combined ratios3 during 2005/6 2006/7 2007/8 2008/9 2009/10 2010/11 2011/12 2012/13 phase I have been high this largely reflects the gradual strengthening of outstanding claims provisions in the state-owned insurers (offset in part Non-life direct premiums because expense rates dropped slightly over this period). The private sector 2,804 3,274 4,170 4,750 5,174 5,655 6,089 6,954 LE million accounted for 45 percent of non- life premium income in 2010/11 following its Life direct premiums LE more aggressive entry into the motor insurance market (Table 4.1). 2,146 2,946 3,514 3068 3608 4,000 4,518 5,267 million Figure 4.1: Private Sector Re-entry to the MTPL Market Non-life penetration 0.45 0.44 0.47 0.45 0.43 0.42 400,000,000 350,000,000 Life penetration 0.35 0.40 0.39 0.37 0.36 0.32 300,000,000 GDP deflator rate 7.4 12.6 12.2 11.2 10.1 10.5 250,000,000 SOI share of non-life 200,000,000 89.7 76.6 66.8 59.5 57.4 55.0 54,0 45,9 market 150,000,000 SOI share of life market 70.3 56.4 50.9 46.8 46.8 47.6 36,1 35,5 100,000,000 AUM LE billion 18.7 21.3 29.0 28.9 31.7 35.3 39,6 38,0 50,000,000 0 Percent of GDP 3.0 2.9 3.2 2.8 2.6 2.6 1 2 3 4 5 6 7 8 9 0 1 01 00 00 00 00 00 00 00 00 00 01 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 10 00 01 02 03 04 05 06 07 08 09 20 Net combined ratio – non 20 20 20 20 20 20 20 20 20 20 155.9 149.9 152.9 110.7 124.9 114.5 107,4 110,6 Public Sector Private Sector life Source: Misr Insurance Holding Company. Investment return – 11.8 10.9 15.3 7.2 8.3 7.8 8,3 8,1 whole sector The estimated industry solvency ratio4 of 268.1 percent at end 2010/ Net expense rate – non 34.9 32.8 30.6 27.1 30.3 32.1 34,7 38,0 2011 would be reduced once adjusted for aged receivables, other non- life sector admissible assets and remaining understatements of policyholder liabilities Net expense rate – life in the state-owned insurers. The solvency ratios during the reform period 24.2 19.8 16.7 21.0 23.8 22.7 25,8 26,2 sector were initially overstated as they reflected the gross understatement of Estimated unadjusted policyholder liabilities in the state-owned insurers. However, the industry as solvency ratio to total 572.3 470.2 810.2 442.3 390.2 268.1 sector a whole appears to be adequately capitalized. Note: Penetration is gross premium income expressed as a percentage of GDP. Non-life penetration reduced in the period to June 2010. This reflects Source: EISA/ EFSA annual reports, IMF country data, SOI annual reports. greater price competition in certain industrial and commercial lines combined There are more than 600 private pension funds (although 25 accounted with a period of rapid economic growth (increasing the denominator faster for more than half of assets under management) with most not being than the numerator in the ratio). Consumer classes, including MTPL, health effectively supervised. Actuarial reviews were only required every 5 years and individual life have shown real positive growth rates. However, increased (increased from 3 years because of a lack of actuarial capacity) and a lack of access to insurance for the less privileged sections of the community will 120 Financial Development and Inclusive Growth Non-Bank Financial Institutions 121 need to be addressed in any ongoing future generation reform program. Table 4.3: Misr Insurance Performance Ratios (Percent) Private sector insurers account for more than half of the MTPL market, representing a significant positive deliverable under the reform program. 2009 2010 2011 2012 Anecdotal evidence indicated that several smaller insurers might now be viable as a result. Non-life Total MTPL Other Total MTPL Other Total MTPL Other Total MTPL Other The performance of the private pension sector has been, if anything, retrograde and key reforms, especially the passage of the draft Private Gross written premium 2,816 349 2,467 2,971 262 2,709 3,108 267 2,84 3,701 245 3456 Pension Law still need to be addressed. While investment returns are LE million stable due to approximately 95 percent of pension fund assets being placed Claims in bank deposits or government paper, they barely cover inflation. This ratio 89.2 268.0 43.4 112.4 518.4 46.6 93.3 359.7 52.1 85.2 343.0 66.9 reflects the part time, non-professional and overly conservative nature of the management of most of the funds. The reported expense rates also seem Expense 24.4 14.8 27.0 29.5 11.2 33.2 32.4 22.5 33.9 24.8 18.2 20.4 ratio excessive. In sum, there is considerable scope to improve both the governance and the management of most private pension funds. Operating profit 37.9 -55.6 62.7 -.0.5 -221.6 43.4 14.3 -125.4 36.1 margin Table 4.2: Private Pension Funds (2004-2011) Source: IHC. 2003/4 2005/6 2007/8 2009/10 2010/11 AUM LE billion percent 14.2 18.6 23.9 29.8 32.9 Table 4.4: Misr Life Performance Ratios GDP 2.9 3.0 2.7 2.5 2.4 Life 2011 2012 2013 Investment Return percent 9.8 9.6 9.8 9.2 8.9 Net premium LE mill. 1,441 1570 1770 Expense rate* percent 2.8 4.9 3.7 7.3 4.8 Acquisition cost ratio 14.1 18.2 18.8 *Before provisions. Admin. Cost ratio 14.1 14.5 13.8 Source: EISA/EFSA annual reports. Yield on math. reserves 4.4 The performance of the state-owned insurers (Misr Insurance and Source: IHC. Misr Life) during is difficult to gauge from published data. This is because it includes the costs (including reserve strengthening) of the restructuring, Misr Insurance has reduced market share accounts in part for a high recognition of capital gains and losses, and the impacts of major transfers ratio of MTPL technical provisions to earned premium as its technical of risk and assets portfolios and of staff.5 In addition Misr Insurance paid provisions reflect uncapped business written many years into the past when nearly LE 500 million in dividends in the 2 years prior to the revolution. In the state-owned insurers had virtually the whole of the MTPL market. November 2011, the General Assembly of Misr Insurance agreed to transfer The key ratios highlight the current balance sheet strength of the two LE 350 million of general reserves to capital, leaving the company with LE remaining state-owned insurers. The solvency positions of both insurers are 2 billion of capital.The state-owned insurers have effectively operated as strong and insurance liability provisions and reserves have been significantly specialist non-life (Misr Insurance) and life (Misr Life) insurers since June strengthened. Misr Insurance shows adequate profitability. However, Misr 30, 2008 and a revenue account ratio analysis can be carried out over that Life’s aggregate expense rate remained high at the end of 2008/9 for a mature period. Balance sheet strength can also be assessed based on the restated life insurer, mainly reflecting the Al Chark excesses (Table 4.5). June 30, 2011 accounts (Tables 4.3 and 4.4). Table 4.5: State-Owned Insurer General and Administrative Expense Ratios* 2010/11 2011/2012 2012/13 Life activities 13.5 14.5 13.8 Non-life activities 10.8 8.8 9.6 * As a percentage of gross premium revenues. Source: Misr Insurance Holding Company. 122 Financial Development and Inclusive Growth Non-Bank Financial Institutions 123 The June 2011 financial reports showed a worrying trend. In the 2010/11, salary levels at the time of writing, deficits of up to LE600 million have been Misr Life had an overall expense rate of 28 percent compared to a private projected if current levels of supplementary salary increases are assumed to sector expense rate of 20 percent: as late as 2009, it had a better expense increase at current rates. rate as the private sector life insurers. At June 30, 2011, Misr Insurance A governance challenge specific to the state-owned insurers is had 4,105 staff and Misr Life had 5,105 staff (an overall SOI staff reduction the issue of staff indirectly holding agencies through family members. of 20 percent since June 2005). Generous salary and agency remuneration Decree 245 of 2008 states that the staff of insurers, except those working increases have been reflected in significantly increased expense rates at a in sales and marketing, may not hold insurance agencies. Amongst time when revenue sources are under pressure from increased competition other objectives, this rule is intended to protect Misr Insurance against and reduced investment returns (Table 4.6). Some indication of the current conflicts of interest when insurance risks are priced. However, SOI staffs, level of staffing relative to benchmark can be found from international including managers, continue to hold agencies through family members comparatives, after adjusting for PPP income levels (Table 4.6). and the Decree should be extended to cover immediate family members of ineligible staff (including all staff whose job description does not include Table 4.6: Adjusted Premium per Insurance Employee Normalized Egyptian PPP GDP/ Capita-2009 (LE1000s) directly selling new business). Egypt Sectoral Structure and Performance (state- Country Germany Spain France Poland Turkey UK owned Insurance Sector insurers) If structural, cultural and other economic variables are introduced Adjusted premium per 55.8 122.8 191.5 224.1 126.7 135.6 175.3 Egypt’s insurance penetration is better than expected for life and about staff equal to expectation for non-life, despite its being an underperformer Source: CEA Statistics No 42, November 2010, Axco Reports. relative to income level. Key variables holding back sectoral development include the lack of development of credit at the small business and The Egyptian state-owned insurers appear to have approximately 2.5 household level, inflation rates (for life insurance), government domination times the staff counts normalized to PPP adjusted premium as the least of the non-life insurance sector, and cultural effects (i.e. a lack of clarity efficient European countries. More accurate benchmarks could be obtained as to the acceptability of certain forms of insurance under Islam). Positive by examining domestic private sector insurer staffing levels and separating explanatory variables affecting life penetration are population density and direct sales staff from other staff, but this would be unlikely to change the the emergence of a middle class with discretionary income. conclusion. A related issue is the legal right of SOI staff to 10 percent of profits. Such expectations can create pressures on management to overstate Figure 4.2: MTPL Premium Penetration Versus Vehicle Density profits, usually by understating policy liabilities. 3 A detailed examination of Misr Insurance’s profit sources shows 2,5 Motor premiums/GDP that it is effectively acting as a conduit of funds from government-owned enterprises in order to subsidize motor vehicle owners and fund the excess 2 staffing levels discussed above. As long as Misr Insurance is able to maintain a preference in the placement of government business, it can stabilize 1,5 returns through reinsurance and exchange commission income. This hidden cross subsidy from key productive sectors of the economy is inefficient and 1 JOR not sustainable in the long term: strategies to deal with MTPL underpricing MAR TUN and overstaffing of the state-owned insurers will need to be developed. 6 BHR 0,5 In the case of Misr Life the overstaffing issue is potentially of existential SYRDZA OMN ARE QAT importance as its expense rate is now well above industry norms. LBY KWT SAU 0 EGY A short/medium term threat to Misr Life’s balance sheet is the impact 0 100 200 300 400 500 600 700 of high supplementary salary increases on group life pension contracts written for the public section of the insurance sector (including some EFSA Cars per 1000 people staff). While these contracts were in approximate balance based on current Source: World Bank Database. 124 Financial Development and Inclusive Growth Non-Bank Financial Institutions 125 A highly predictive variable for Property & Casualty (P&C) penetration Supplementary Pension Sector is the size of the national car fleet. On this measure Egypt is well behind There are two types of standalone supplementary pension arrangements expected premium levels. The most obvious reason for this state of affairs in Egypt, one of which currently is subject to full EFSA oversight. The first is the ongoing inadequate premiums being charged to cover certain MTPL is entitled Private Pension Funds (PPFs) and covers approximately 3 million risks (although the shortfall has recently been reduced due to corrective employees. Most PPFs are occupational plans (usually for public sector action on the part of the previous government). However, there is also scope employees) and they have historically been set up on a) DB basis, although more to investigate levels of car owner compliance with the mandatory purchase of recently formed plans have adopted a Defined Contribution (DC) approach. As MTPL insurance, and whether vehicles are properly classified when MTPL at the end of June 2010, there were 632 such plans of which 25 operate on a coverage is purchased. DC basis. As mentioned above the funding status of the DB plans is gradually An important line of business that has not been modeled is health being determined under a stepped program instituted under the first generation insurance. This is one of the fastest growing classes of insurance in emerging reforms (Table 4.8). Funding levels appear to have improved since the 1st markets, and the Middle East in particular, as governments attempt to create generation supervisory reforms were introduced. Remedial action continues to fiscal space.7 Egypt lags behind its regional peers in terms of health insurance be taken to the extent possible under the existing inadequate law. penetration, possibly reflecting its current high level of coverage through social transfer arrangements and a large rural population. An additional risk Table 4.7: Private Pension Funding Levels (May 2012) factor associated with health insurance is the lack of a regulatory framework Funding Ratios Number of Funds Percentage governing the operations of health insurers. Prior to January 2011, the Ministry Less than 60 percent 23 5.4 of Investment and EFSA drafted a legislation to regulate this industry; 60-80 percent 42 9.9 however, it is not yet a priority on the reform agenda by the government, 80-90 percent 59 13.9 A distribution channel that has yet to be fully exploited is 90-100 percent 65 15.3 bancassurance. The three life insurers (including CIL, the largest by new business) gain most of their business through this channel. There had 100-125 percent 122 28.8 been a freeze on any new bancassurance agreements being approved by More than 125 percent 113 26.7 the central bank. This freeze was justified as the applicable rules needed Total 424 100.0 to be strengthened and there was evidence of banks mis-selling through Source: EFSA. unlicensed staff. There is as yet no internationally accepted standard model of bancassurance and country specific regulation tends to be ad The second type of retirement savings arrangement, is termed a hoc. In May 2013, CBE reauthorized bancassurance with new set of syndicate plan, and is now subject to partial EFSA oversight. These also regulations that included hedging the risk borne from the insurance tend to be designed around DB principles, and are established to cover the company, complete separation between the activities of the insurance large memberships of various professional and vocational bodies, such as company and the bank, in addition to transparency. EFSA has also accountants, tour guides and engineers. The 3-syndicate funds reviewed to allowed postassurance in the second quarter of 2014. date (out of 10) appear to be reasonably well funded. However media reports The low retention ratios reported for the Egyptian insurance sector dating back at least three years (news.egypt.com) refer to certain syndicate indicate that significant underwriting is taking place in foreign reinsurance funds experiencing severe cash flow shortages–despite paying minimal offices or parent companies. While low retentions are justified for very large pension benefits–and implying that they have zero funding ratios (i.e. are risks such as those in the oil industry (called ‘peak risks’ in the industry), it now on a PAYGO basis). Aside from these standalone arrangements market is difficult to understand why classes such as fire (retention 26.1 percent), intelligence indicates that a significant proportion of pension arrangements accident (retention 63.7 percent) and health (retention 61.5 percent) are are now managed through life insurance groups and individual policies. A being reinsured to such a large extent given the more than adequate capital number of private pension funds have wound up and have been transferred employed in the sector (see Annex 5 for retention ratios by class of business). to insurance companies. One possibility is that some insurers are ‘fronting’ and their proprietors are Key Challenges Confronting the Contractual Savings Sector happy to accept the more reliable but potentially lower income available from reinsurance exchange commission. A negative outcome from such a business MTPL (‘ACT’) Insurance. The main technical challenges continue to model is that local underwriting skills are not being developed and there is be maintaining the stability of the MTPL insurance non-life portfolio in Misr little incentive to develop the non-life insurance market. Insurance. Although Misr Insurance has significantly strengthened its own 126 Financial Development and Inclusive Growth Non-Bank Financial Institutions 127 technical reserves, it inherited an enormous technical reserve shortfall when non-life insurers. In addition there is at present no credible data set on which it took over National Insurance’s ‘Act’ insurance claims portfolio in 2009. In to base such policy decisions. Ideally, the correct premium rates should be addition, claims provisions for business written before claims were capped charged based on detailed actuarial analysis however, social groups (e.g. (under Law 72 of 2007) continue to prove to be inadequate as the claims taxi drivers and privately owned light transport) this may not be possible are run off (Table 4.9). This reflects National’s former dominant role in the in the current environment. Thus in the short term the best approach may MTPL business and the dependence of a segment of the legal profession on be to establish a separately managed pool for certain classes of commercial representing accident victims and their need to generate income from the old vehicles and for the insurance sector and government to jointly subsidize this claims portfolio during its run off period. On the other hand, the business pool on a transparent basis. written since the claims cap was instituted and premiums were increased If EFSA is to be able to justify future increases in MTPL premium rates is providing an adequate overall return to underwriters, although some (particularly for socially sensitive groups) it will need an excellent database categories of vehicle continue to be highly unprofitable. feeding into a modern actuarial premium setting practice. For this reason it is essential that a central data repository is established by the Insurance Federation Table 4.8: MTPL Loss Ratios* (2007-2013) (percent) to gather policy and claims data by vehicle and driver. This information could Accounting Year 2007 2008 2009 2010 2011 2012 2013 have a range of uses including helping to assess the general level of required State owned Insurers 846.8 635.2 261.1 452.3 377.9 343.0 228.1 outstanding claims provisions (i.e. through actuarial examination of claims run Private insurers 267.1 131.2 28.5 59.2 66.7 37.3 40.9 off patterns) and hence enable the authorities to establish pure risk premium rates. It would also enable the authorities to clearly identify the highest risk *Claims ratio is claims cost over corresponding earned premium. Source: Misr Insurance Holding Company. vehicles (typically taxis, motor cycles and commercial transport) and begin to require appropriate risk management measures such as driver training. Finally, Accounted loss ratios tend to understate real claims ratios in growing it would enable the relevant bodies to identify car owners who are either not portfolios and the private sector experience will almost certainly deteriorate buying compulsory insurance or who are misclassifying their vehicles to reduce with time, but not to the levels being experienced by Misr Insurance. An premiums. A system to achieve this has been developed successfully in Turkey alternative approach which helps to identify the impact of the old system and currently Saudi Arabia is developing its own system. business is to examine Misr Insurances post 2007 experience by underwriting SOI expense rates. While it is desirable that market level compensation year (Table 4.10). is paid to all SOI staff, in order to attract high quality recruits, this will not be possible until Misr Insurance and Misr Life also attain competitive Table 4.9: State-Owned Insurer Claims Ratios by Underwriting efficiency (i.e. premium per staff) levels. A generous retrenchment structure FY business written 2008/9 2009/10 2010/11 2011/12 and natural attrition, combined with modern performance review systems Claims ratio developed to date percent 65 178 92 83 are three methods of dealing with this. Both state-owned insurers have developed medium term attrition plans based on the relatively high average Source: Misr Insurance Holding Company. age of their staffs. In the interim only essential recruitment for specified The differential (DIFF) experience of the post 2007 business between skills enhancement should be allowed. public and private insurers reflects the fact that under the current regime Private pensions. A Private Pension law has been drafted and was private insurers are able to select the best risks while Misr Insurance continues submitted to the Cabinet of Ministers in November, 2010 and since the to have to also accept inadequately rated and hence loss making commercial revolution, and the dissolution of Parliament, the law has been pending. This vehicle (including taxis) business. As noted above Misr can continue to cross law is not controversial and is essential if EFSA is to be able to do its job subsidize motor insurance from excessively priced government sourced properly, ensure that private pension funds are professionally managed and business but in a competitive market and given current fiscal pressures this to clarify relevant tax incentives. will become increasingly more problematic over time and is undesirable from Of more concern is the status of the syndicate funds. Any resolution of a public policy perspective. this subset of funds is likely to require a considerable diagnostic effort, a major The standard approach to the incentive problem described above (i.e. restructuring program, and possible government financial contributions. the worst risks being effectively diverted to government owned insurers) is Insurance and private pension supervision. Unfortunately, following to establish an ‘assigned risks pool’ for loss making commercial business and the unexpected departure of the first Chairman of EFSA, and a freeze on senior to allocate this to all non-life insurers according to their market shares. The appointments imposed by the interim government, progress towards the planned concern in Egypt is that this will upset the development of the private sector functionally based structure of EFSA has stalled. Recently applied salary caps 128 Financial Development and Inclusive Growth Non-Bank Financial Institutions 129 have also significantly reduced the incomes of senior EFSA staff (reflecting A related issue is the level of household savings in Egypt intermediated low civil service minimum salaries) and key individuals have already departed through banks. Combining the assets of the private pension funds and life for better paying jobs in the private sector. The new management of EFSA is insurers with household term and savings deposits produces a sum equal to 41 currently undertaking a thorough review of the insurance law, its executive percent of GDP (Table 4.11). However, the institutional investors only capture regulation and the private pension executive regulation. Advisory committees a small fraction of household savings. This situation has hardly changed in including experts and market participants are working on drafts to be followed recent decades and indicates that the general public has yet to gain a familiarity by public consultations in the second half of 2014 as indicated by EFSA. with and trust in, the insurance sector as a medium for long term savings. In the interim the insurance and pension, SDP has been partly implemented. Until recently, the sales that have occurred in the life insurance sector have However, there is a need to further develop the capacity of EFSA to risk rate had a significant single premium investment linked component. institutions and to introduce an enforcement and sanctions regime commensurate If institutional investors were to successfully begin dis-intermediating with these ratings. Ideally, the supervisor should be able to produce a detailed risk significant savings from the banking sector, it appears likely that they would matrix for each insurer and pension fund incorporating both hard numerical analysis be obliged to place funds with the government in order to support domestic (including IRIS and solvency ratios) and the current qualitative inputs. borrowing needs. Given that, at the time of writing, all but one outstanding Group Life Contracts in Misr Life. As noted above the new management government bond issue matures in 2016 or earlier, the scope for the provision team in Misr Life (formerly National Insurance) has inherited a group life pension of the long-term guarantees that underpin traditional life products will portfolio that is difficult to fund when salaries are rapidly increasing. A particularly remain quite limited. Thus, the future of the life insurance sector is in part generous component of this business covers employees of the state-owned insurers, linked to government macro management. This in turn will be influenced insurance supervisory staff and staff of the Insurance Federation. This component by the social transfer arrangements implemented going forward, and in places no cap on salary increases allowed for determining ultimate benefits, while particular the success of the new government in targeting those most in most other group life pension plans do impose such caps. If current generous salary need and creating fiscal space by requiring the better off to make their own increases are maintained the liability valuation actuary will be required to change supplementary arrangements. his assumptions and this could severely damage the recently repaired Misr Life Pensions. The Law 135 of 2010 introduced a fundamental restructuring (formerly National Insurance) balance sheet. The best solution would be to put of pension and related social insurance benefits in Egypt. This reform became public sector insurance staff group life arrangements onto the same basis as other necessary because the existing model was inequitable, had limited coverage group life arrangements. The legal steps required to achieve this should be explored. (despite a constitutional guarantee) and was becoming fiscally unsustainable (Figure 5.3). In addition, the high employer contribution of 26 percent (in Opportunities Going Forward part on full remuneration) was pushing firms into the informal sector or A basic question that needs to be asked is whether the new government encouraging them to understate salaries. post-revolution is prepared to allow the state-owned insurers to be run on a fully Key features of the new system include significantly reduced commercial basis given the employment imperative. The financial sector can contribution rates (offset by the removal of salary caps for both contribution support efforts to create fiscal space and through its intermediation and risk and benefit purposes), a guaranteed basic demogrant (i.e. retirement income) management roles, it can encourage and support economic development. However and individual defined contribution accounts with guaranteed minimum if it is used directly to provide employment it is likely to perform poorly in these returns (to be supplemented by a central solidary fund). A central board will roles, and inefficient subsidies consequently become necessary. determine investment policy with between a third and 45 percent of funds Table 4.10: Household Savings through Financial Institutions in Egypt potentially going to investments other than government securities.8 The extent (LE billion) to which these funds will be invested through private fund managers is not clear, although the a significant private sector involvement is preferable as it June 2008 June 2009 June 2010 June 2011 would ensure a disinterested approach and reduce the potential for later fiscal Time and Savings Deposits 330.1 388.3 448.3 447.5 strains arising from poor returns related to politically directed investments.9 Life insurance math. reserves 12.7 14.2 16.4 17.8 The impact of this reform on private institutional investors is likely to be Private pension AUM 23.9 26.7 29.0 30.1 negative unless certain further amendments are made. Advisers have already Total 366.7 429.2 493.7 498.6 suggested that private pension funds will not be necessary for new employees Percent of GDP 40.9 41.2 40.9 40.8 (younger employees may also switch to the new system). If this advice is followed, existing private pension funds will become closed funds and are likely Source: CBE, EFSA. to experience increased funding problems in the absence of new entrants. Life 130 Financial Development and Inclusive Growth Non-Bank Financial Institutions 131 insurers may benefit in the short term as DB funds are wound up, converted prepared to pay the additional cost of accessing private primary care and to DC arrangements and transferred to professional management (as required hospital facilities.14 Public hospital utilization is barely 40 percent. Reasons by the proposed private pension law). However, in the longer term the role of for avoiding the government facilities that are available free of charge include institutional investors in Egypt is likely to be severely curtailed (the central fund long waiting times (which many cannot afford), poor equipment, crowding excepted). One possible approach, which could help to create fiscal space given the and the need to sometimes pay baksheesh. In addition, some costs such as lab economic challenges Egypt will be facing, is to re-impose caps on contributions fees and drugs, are not free. For these reasons, other initiatives that will help and benefits, but to do so in a way that would introduce greater progressivity in to transfer some of the load to private sector providers (and again possibly the pension system (i.e. more transfers from the well off to the poor). This would increase fiscal space), and increase coverage (such as expanding the coverage leave scope for those with higher incomes to seek supplementary retirement of micro-insurance) should be supported. income from insurers and private pension funds. Micro-insurance. Approximately 41 percent of Egypt’s population is classified as living under the national poverty line with the majority of the Figure 4.3: Fiscal Balance - Old and New Public Pension Systems poor largely confined to the informal economy, and concentrated in Upper Current PAYG balance (including investment income), Consolidated current PAYG balance (new+old schemes), Egypt. Thus a significant proportion of the population has no or limited of GDP of GDP access to financial services. In practice, this group has also had little access 3.0% 4.0% to social insurance mechanisms. 2.0% 3.0% Surveys indicate that microfinance already accounts for the major part 1.0% 2.0% of the financing of small informal sector entrepreneurs in Egypt, although ’95 0.0% percent of the demand for microcredit remains unmet’ (Planet Finance). The -1.0% 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 1.0% micro insurance initiative in Egypt is currently focused on protecting micro 0.0% loans and to date has been confined to joint efforts between Allianz insurance -2.0% 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 -1.0% and two local NGOs, and Misr Life and Principal Bank for Development and -3.0% Agricultural Credit (PBDAC). Thus, it is mainly protecting the lenders rather -2.0% -4.0% than households. Workshops in numerous countries, including Egypt, show -5.0% -3.0% that the working poor would be enthusiastic purchasers of micro insurance old scheme new scheme 1.1 new scheme 1.2 new scheme 2.1 reform 1.1 reform 1.2 reform 2.1 reform 2.2 if the product were delivered through trusted institutions and were designed new scheme 2.2 new scheme 2.2 cap min pension to meet the target market’s specific payment and claims management needs. Source: Maait. Once Misr Life is put onto a sounder footing its management could possibly Note: Reforms 1 and 2 assume different allocations between invested assets and transfers to government. consider setting up a specialist micro-Takaful window to meet the needs of Reforms 1.1 and 1.2 (and 2.1 and 2.2) assume different earning rates on invested assets. the conservative population currently not served. Health insurance. A major restructuring of health services funding Takaful. Eight Takaful insurers have entered the Egyptian market, and provision is being tested through a series of pilot programs for similar the first in 2007 and the balance since 2008 (three were family (life) and five reasons to those underlying the pension reforms. Rationalization of a were non-life). These are commercial enterprises, although their business fragmented and inefficient system and the wide use of political patronage model is to provide a facility for those consumers who prefer a cooperative to gain access to better quality facilities (often with PTES (Program for model more consistent with Shari’a principles. While it is still too early to Treatment at the Expense of the State) funding) are additional specific issues determine the ultimate success of these new insurers (although at least one needing attention.10 Overriding these concerns is the fact that despite the has already withdrawn), experience in other contiguous markets indicates constitutional guarantee, approximately 72 percent of all health expenditure that non-life Takaful insurers tend to compete for existing business15 while in Egypt is out of pocket (OOP).11 The future of this reform program, which life (‘family’) has more potential to increase overall insurance penetration. includes greater decentralization of authority under the MOH system, and Reinsurance. Egypt Re., the state owned reinsurer was merged into the enrolment of rural families in a primary care system remain unclear.12 Misr Insurance as part of the restructuring of the state-owned insurers. This This reform is likely to be less of a threat to private sector insurers was largely because its existence was enabling direct insurers to underprice given the political and operational challenges entailed, and the necessary lead risk and pass it on, effectively to the State, and because that way its net times in raising the quality of government health care provision to the public assets could be better employed in supporting the direct insurers’ capital at large.13 Surveys demonstrate that even a majority of the working poor are needs. More than 50 percent of its business came from domestic insurers and it was earning inadequate returns on the public funds invested in its 132 Financial Development and Inclusive Growth Non-Bank Financial Institutions 133 balance sheet. As part of Misr Insurance, the business can be run down Figure 4.4: Mortgage Debt Figure 4.5: Mortgage Debt efficiently, yet in practice, other insurers have little incentive to make Outstanding Outstanding facultative16 placements with a competitor. Given the long history and 6,000 0.70% reinsurance placement skills of the Egyptian insurance sector (especially 0.60% following the SOI restructuring) it seems unlikely that Egypt (in common 5,000 with many developed countries) needs a national reinsurer. However if 0.50% there is a desire to establish a second local reinsurer (Africa Re’s Takaful 4,000 % GDP EGP m subsidiary was recently established in Cairo) it should have strong regional 0.40% focus and be privately funded. 3,000 0.30% 2,000 0.20% Mortgage Market 1,000 0.10% Mortgage Market Development Egypt’s Mortgage Market grew rapidly during the period 2006 to - 0.00% 2010, although it still remains small relative to the overall economy and the 06 07 08 09 10 06 07 08 09 10 ar ar ar ar ar ar ar ar ar ar overall size of the financial system. Much of the initial growth was led by M M M M M M M M M M the banks and the Mortgage Finance Companies (MFCs) followed. Although MFCs Banks Source: Egyptian Financial Supervisory Authority, IFS Database. recently data for banks have been difficult to obtain it would appear that during 2010 and into 2011, very little mortgage lending was done by banks. Figure 4.6: Mortgage debt-to-GDP Future growth of the sector is likely to depend at least in part on (i) 18.0% further lending by MFCs, assuming they are able to fund their expansion (ii) 16.0% growth in the government’s lending programs, possibly under the National Housing Plan subsidized loans program which is being phased out or more 12.0% likely, under the Mortgage Finance Fund affordable mortgage finance 10.0% program (iii) an improvement in property registration nationwide. 8.0% Egypt’s Mortgage Market 6.0% Egypt’s mortgage market is a relatively recent development for the financial sector. Egypt has made significant progress in launching a mortgage 4.0% finance system, reforming the land and property registration system, 2.0% formulating a more conducive property tax law and a Unified Building Code, implementing a new Rental Law, and expanding the variety of affordable 0.0% an p. za ain bia ria . o tes it a an n housing typologies offered under social housing programs. ep wa cc isi no Re Ga Om ge rd ira hr ra bR n ro ba Ku Jo Tu Ba iA Al ic Mo Em k& Le ra am ud Just after the Egypt’s revolution in 2011. The Peruvian economist t, A an ab Sa Isl tB yp Ar n, Hernando the Soto published an essay17 in the Wall Street Journal Eg es d Ira ite W Un discussing the relationship between property rights and the causes of Source: World Bank mortgage database collated from Central Banks and other national sources. the revolution. He succinctly summarized one of the drivers of discontent with the Mubarak regime as: “More than 90 percent of Egyptians hold Despite the rapid growth in Egypt’s mortgage market, it still lags their property without legal title. No wonder they can’t build wealth and behind many neighboring economies. have lost hope.”So although much has been achieved, much also remains A recent paper by the World Bank covering housing finance in the to be done in scaling up Egypt’s mortgage market and bringing mortgage MENA region, attempted to estimate the expected size of a mortgage market finance within the reach of lower income groups. This chapter should be based on certain key variables such as overall level of wealth as measured seen within the context of the broader financial sector development, but by GDP. The charts below show the significant opportunity that exists in also merits stand-alone consideration as a roadmap of recommendations for Egypt to further expand the mortgage market. In the exercise, MENA region future development of the mortgage sector. 134 Financial Development and Inclusive Growth Non-Bank Financial Institutions 135 housing and mortgage markets were modeled to measure the gap between ϘϘ Enactment of the Real Estate Finance Law 148 of 2001—the basis the current and potential depth of housing finance markets. Housing loans/ for all the reforms, which established the institutions to regulate the GDP and housing loans/total loans were regressed against several variables, mortgage sector, creating the Guarantee and Subsidy Fund (GSF), and including income per capita, population size and density, and inflation. For prescribing the rules for the types of loan products which banks and both regressions, the model shows that for most MENA countries, mortgage mortgage finance companies are permitted to offer borrowers. finance is below expected levels. This discrepancy indicates the potential ϘϘ Creation of the Mortgage Finance Authority (MFA), whose for mortgage finance to grow in these countries as well as the potential to functions were incorporated into the remit of the Egyptian Financial progress toward attaining international reference levels, without significant Supervisory Authority (EFSA) in July 2009—a key step in creating new demographic or economic developments. The area below the diagonal a secure and strong regulatory environment to protect the interests line represents an under-performing market. So Egypt with just 0.6 per cent of lenders and consumers. The importance of strong regulation has of mortgage debt to GDP has an expected market of closer to 2 per cent of been underlined during the current crisis. GDP or at least 3 times larger than currently. ϘϘ Establishment of a mortgage liquidity facility—the Egyptian Housing Loan Product Penetration Mortgage Refinance Company (EMRC) in June 2006, that enhances mortgage leaders access to term re-financing which is crucial for The chart below provides a unique perspective on the Egyptian the establishment of long-term lending and better management of home loan market using the Global Findex Financial Inclusion Survey. financial risks. The data show clearly the low levels of penetration for home loans with formal financial institutions among the adult population. In all areas, ϘϘ Enforcement of foreclosure—the ability to enforce collateral rights Egypt has a lower level than the average across the MENA region. Based is essential to lenders if they are to properly value the collateral in a on a survey of over 1,000 adults carried out in 2011, just 2 per cent of the secured loan. The first cases of foreclosure went through the courts population reported having a loan used to purchase a home or apartment. in 2008, establishing the necessary legal precedents to give comfort The most surprising output of this survey may be that the group, which to mortgage lender. reported the highest penetration level, was the poorest quintile of the ϘϘ Streamline property registration—this process has been income distribution. This may reflect the fact that loans for purchasing significantly improved, through a nationwide mapping and titling new properties are not extended by financial institutions but by developers program. In addition, the time it takes to register a mortgage and and would not be included in these results and secondly that the National the fees charged have been significantly reduced. The government Housing Program (NHP) has helped some home buyers at the bottom of the continued to make an effort to address property-registration issues income distribution with 10.5 per cent subsidized loans granted through to facilitate the development of primary markets. the state owned banks. However, the overall level of penetration remains ϘϘ Enhancement of consumer protection and financial education— low even by developing economy standards. minimum disclosure requirements pertaining to loan information and Path of Mortgage Market Reform 2001–200918 consumer education programs are being conducted by the EFSA. These programs are designed to familiarize Egyptian consumers with new The government introduced a number of reforms to promote mortgage financial products and to ensure that they are aware of the terms and and mortgage finance starting in 2001. Most notably was the introduction of a conditions of the product when securing a loan. legal framework that paved the way for mortgage finance, the establishment ϘϘ Set-up the first private credit bureau—I-Score was established of a regulatory authority, the setting up of a fund to support low and middle- income housing, and the creation of specialized mortgage finance companies. to provide timely and accurate information on credit worthiness, Moreover, the mortgage foreclosure regime was modernized, the property which will serve to improve the underwriting process and lower the registration system was improved and fees reduced, and the private credit credit risk for lenders. bureau became fully operational. In July 2009, a new law was issued to create These building blocks have helped in gradually developing the mortgage a supervisory authority for NBFIs. sector in Egypt, attracting foreign capital into the sector and creating steady One of the central goals of Egypt’s previous Financial Sector Reform growth of mortgage loans in both number and geographic spread around Program was to create a vibrant mortgage lending market. A number of major the country. Nine non-bank MFCs were created, and others are currently reforms were undertaken to achieve this. The building blocks for mortgage being formed, but they still only account for a small share of lending due to finance which were put into place include: inadequate availability of long-term funds and delays in registering property titles in the new urban communities. 136 Financial Development and Inclusive Growth Non-Bank Financial Institutions 137 Islamic Housing Finance Economic benefits of housing finance. The section below During the 1970s, a number of schemes were marketed under the provides some theoretical background on the importance of housing banner of Islamic Finance. However, some of these turned out to be investment finance as a driver of growth and some of the other externalities that frauds that resulted in many small savers and investors losing their money. result from investing in housing. This left ordinary Egyptians with a distrust for products marketed as being Deepening financial access. There is a broad array of literature Islamic Finance. Subsequently, Egypt’s leading cleric, Sheikh Mohammed regarding the impact of deepening financial access on poverty levels.19 Gaining Sayed Tantawi, the Grand Imam of Al Azhar Mosque and University - which access to finance can be a way out of the perpetual cycle of poverty that is has been a leading center of Islamic studies for centuries - issued a fatwa prevalent at the bottom of the income pyramid. This ‘poverty trap’ is well indicating that simple bank interest would be permitted as long as it was illustrated in the book ‘Portfolios of the Poor: How the World’s poor Live on $2 not excessive. Thus, Islamic finance in Egypt bears a greater similarity to a day’ which provided a detailed chronicle of the financial lives of households in conventional finance but with a usury safeguard. India, Bangladesh and South Africa. It advanced the proposition that without Based on the fatwa, therefore almost all mortgages in Egypt are credit those at the lowest levels of income will face significant difficulties in technically compliant with Islamic Shari’a law although they are not order to climb out of poverty. Credit allows for unexpected events to be dealt structured in a way that is usually understood as being in accordance with with without causing a slide back down the income distribution pyramid. the principles of Islamic finance. There is a widely quoted figure from a 2009 Improving property rights provides the means of expanding access to McKinsey report that indicated that a mere 3 per cent of Egypt’s banking finance through the use of secured lending. This arrangement reduces the risk assets are in the form of Islamic Finance. The accuracy of this figure is suspect for lenders and improves repayment discipline. Providing collateral against given that in fact regular financial products in Egypt bearing moderate a loan can be especially important in environments where credit history, interest can be considered as being Shari’a compliant as a result of the fatwa. formal payment records and credit bureaus are either scarce or non-existent. This has been accepted by most Egyptians and Egyptian financial Enhanced access to finance enables households to smooth consumption institutions and has not appeared to cause any problems. One of the downsides patterns, manage unexpected costs as well as invest in education, health or of this ruling, however, is that it has meant that the more traditional Islamic directly in a business. In addition to benefits accruing directly to households, finance products for housing have not taken root. Given that Egypt is almost there are also broader benefits for the economy as a whole. A recent IMF the birthplace of Islamic Finance with a pilot project in the village of Mit- paper (Singh 2011), looking specifically at the issue of financial deepening Gahmr in 1963, it seems unfortunate that more progress in this area has not in sub-Saharan Africa, found that there was causality between financial been achieved. deepening and poverty reduction as well as income inequality reduction. It also concluded that stronger property rights reinforce the effects of private Having a financial system that includes housing finance in the form of credit expansion on poverty reduction. Musharakah (profit sharing structure), Ijara and diminishing Ijara (housing leasing structure) or Mudarabah (also profit sharing but with greater risk Unlocking ‘dead’ capital, the classic exposition of the power of for the lender) alongside traditional interest bearing products could be property in enhancing access to finance is De Soto (2003), The Mystery of considered. Additionally funding for these loans could tap into a different Capital. He sets out convincing arguments about the vast sums that are class of investors using Sukuk bond issuances. Given the growth in this locked in property. Improving property rights and allowing this property to sector across the MENA region, Egypt could consider developing some of be used as collateral for loans, could unlock an expansion of investment at these products even with its unique Egyptian fatwa, even in the absence of it the bottom of the income pyramid. In practice, some of these arguments may being necessary under its Shari’a law. have been somewhat exaggerated, just as the sub-prime crisis demonstrated that lending solely based on collateral is not a prudent approach. Secondly, Mortgage Finance as a Driver of Growth De Soto implied that poor households were all budding entrepreneurs capable Currently, one central theme of global development policy is job of making informed business and investment decisions. As with the rest of creation. One of the benefits of promoting housing as a policy objective is the income distribution, this is not always the case and many households will both the tangible improvement in living conditions but also the potential jobs tend to be risk averse, preferring not to risk losing the little property they do created. Many of the jobs will be low skilled and are therefore very accessible. own by putting it up as collateral. This section of the chapter considers a theoretical framework of benefits Driver of construction, Duebel (2007) postulates that housing arising from housing finance and then seeks to put this into the Egyptian finance is a direct driver of construction output. However, he also suggests context by looking at the potential expansion in housing and housing finance that this relationship only holds true in cases where the construction sector and the benefits for the Egyptian economy. is able to freely expand, and this is dependent on access to serviced urban 138 Financial Development and Inclusive Growth Non-Bank Financial Institutions 139 land and also to developer financing. Mexico and Malaysia are both good Social Benefits of Housing Finance examples of countries that have seen their housing production rise as a result Numerous benefits can be ascribed to improving access to housing of expanding the housing finance system. finance and thereby housing. Homeownership has long been promoted as a Housing multiplier effect. This is a central argument in favor of way of giving individuals a stake in society and a stake in the economy. By housing investment. The premise is that every unit spent on housing will having a stake, which can increase in value, it provides an incentive for the generate a multiple amount of benefit for the economy, as it creates jobs homeowner to look after the property and to maintain the neighborhood in through horizontal and vertical supply chains. This includes jobs in areas which the house is situated. This theoretically results in lower crime levels such as raw material production, mining, cement production, timber and and improved quality of life. Other social benefits that have been observed aggregates. In addition, there are also impacts on local economies where the arising from homeownership are lower fertility rates. This is a less intuitive construction jobs are created, and in the service industries linked to housing, benefit, but if the house is fully owned, parents in emerging markets where such as mortgage lending, real estate agents, retailers of home goods such there is no pension system, no longer have to rely on their children in their old as furniture or white goods. Although the multiplier argument is used age for somewhere to live. Lastly, further benefits include improved health, routinely, there is no clear methodology or agreement on how to calculate through better and safer construction, and improved sanitation. the multiplier effect. There are several country studies that have looked at this effect; unfortunately, very few have looked at this issue in relation to Figure 4.7: Egypt and Peers Urbanization rates 1950–2050 emerging markets however: 100 90 United States - The multiplier effect accounts for the fact that income earned in other sectors of the economy as a result of a home sale is 80 Lebanon then re-circulated into the economy. The National Association of Realtor’s 70 Saudi Arabia macroeconomic modeling suggests that the multiplier is between 1.34 and 60 Jordan 1.62 in the first year or two after an increase in spending. This means that 50 Turkey each dollar increase in direct housing activity will increase the overall GDP 40 Tunisia by $1.34 to $1.62. Morocco 30 Argentina–A 2006 study found that the multiplier effect, just on Northern Africa 20 World the production side of raw materials and direct inputs for housing had a 10 Egypt 1.6 multiplier effect. Further indirect employment effects are also present in related industries. (See Duebel 2009) 0 Australia - The total multiplier for output and employment in the 50 55 60 65 70 75 80 85 90 95 00 05 10 15 20 25 30 35 40 45 50 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 construction industry is estimated by the Australian Bureau of Statistics to Source: UN Populations Division, World Urbanization Prospects 2009 Revision. be 2.866. Therefore, for every $1 million increase in construction output, there is an increase in output elsewhere in the economy of $2.9 million. (Source: The above provides some compelling arguments in favor of housing, the Housing Industry Association) list is not exhaustive and the exact magnitude of the economic benefits will be Scotland–Some of the most detailed work has been done looking at dependent on the environment in which the changes are made. A financial system multiplier effects for Scotland (Whitehead 2010). The results show that that benefits from a developed capital market and an efficient land allocation the gross value added to the economy through different multiplier effects system will clearly be in a much better position to expand its housing demand and and channels, is in excess of all other industries. It is roughly a two-fold housing output and reap the benefits of housing expansion throughout its economy. multiplier effect, so for every GBP 1 spent on housing, GBP 2 are generated for the economy. Housing and Land Philippines - The National Economic and Development Authority The demand for housing in Egypt is growing both in terms of numbers of the government of the Philippines found that for every 1 peso spent on and also the quality and size of units required. housing activities, an additional 16.61 pesos were contributed to the gross Egypt has a population of 84 million people. The population is currently domestic product. One commentator concluded: “More housing investments growing at a rate of 1.9 per cent annually with the urban population growing and construction mean increases in job generation and sales for allied considerably faster at a rate of 3.1 per cent annually. Around 60 per cent of industries of the shelter sector.” (2006) the population is below 30 years old. 140 Financial Development and Inclusive Growth Non-Bank Financial Institutions 141 The typical household size is approximately 4 people in urban areas Housing Supply and 5 people in rural areas. This is significantly fewer than 20 years ago Prior to the revolution the supply of new housing was growing rapidly when it was 5 and 6 people respectively. There is a strong trend of decreasing with building permits reaching an all-time high. It was becoming evident household size, which further adds to the housing demand burden.20 that the top end of the market was reaching the saturation point, which The chart below shows the rapid rate of urbanization in the region had prompted some developers to start moving down-market. Orascom over the past half century. It is also worth noting that although Egypt is Construction Industries (OCI) for instance had started large scale projects close to the 50 per cent of the global average for urbanization, it is among for the construction of affordable housing. The lower margins available on the least urbanized in the region. In fact, urbanization has stalled over the these projects were compensated for by much higher volumes. past 40 years where it shows no change from the 43 per cent level recorded The chart below shows the rapid rise in the issuance of construction back in the 1970s. This contrasts with countries such as Lebanon, which are permits in Cairo. It has been estimated, given the time interval between the rapidly moving towards becoming fully urbanized societies with urban living issuance of a permit and the delivery of a building that as many as 150,000 accounting for close to 90 per cent of the population. residential buildings would be delivered over the coming 3 years. Given that One of the big drivers for housing demand in Egypt is the marriage one building can represent multiple units the actual amount of construction rate. It is currently at around 600,000 marriages per annum. It is at this taking place is being underestimated. point that newlyweds receive gifts from their family in the form of cash or land and look to set up home in a new house. Government Housing Programs To help improve access to formal home ownership by low and middle Figure 4.8: Egypt Housing Demand (Household Formation Rate) – 000s income households, the government has in the past provided a range of subsidies, 500 through a plethora of special programs. Since the 1950s, social housing programs 450 have focused on delivering finished and relatively high standard housing units, 400 mainly in the New Urban Communities and satellite cities, and at the fringe of 350 existing cities. These government programs are overseen by different authorities; however, the housing models and payment conditions are substantially similar 300 and have changed little over time. Many of these public housing schemes continue 250 to involve large government subsidies. Overall, they have exacted a heavy toll on 200 public finances, making such efforts unsustainable, while satisfying a relatively 150 small portion of the demand and failing to reach the targeted income groups. 100 Figure 4.9: Housing Supply in Greater Cairo 50 30,000 0 25,000 55 60 65 70 75 80 85 90 95 50 00 05 10 15 20 25 30 35 40 45 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 urban rural 20,000 Source: UN Populations Division, World Urbanization Prospects 2009 Revision, Author calculations. 15,000 The annual demand for new housing can be estimated at around 328,000 units annually. This is based on the household formation rate, together with 10,000 changes in demand due to rural urban migration taken from UN Populations Division data projections. The split is 172,000 urban units and 157,000 rural 5,000 units. By 2030, it is estimated that rural demand will disappear completely as the level of urban migration outstrips any natural rural population growth rate. - Other estimates put the demand at a higher level, with the annual 10,05 30,05 10,06 30,06 10,07 30,07 10,08 30,08 10,09 30,09 10,10 30,10 10,11 30,11 10,12 30,12 10,13 30,13 housing demand attaining a level as high as 450,000 units.21 This may include housing needs related to the improvement of current stock and the Permits Issued 100% Delivered 80% Delivered 50% Delivered depreciation of current stock some of which may need to be replaced. Source: Alembic HC, Sector Report, November 2010, Egypt Real Estate. 142 Financial Development and Inclusive Growth Non-Bank Financial Institutions 143 The range of government housing production over the past several decades Cancellation of land sales. The ongoing political environment has ranged from 15,000 to 35,000 units annually, but has significantly increased continues to create uncertainty regarding the potential for more cancellations under the current NHP. NHP has affirmatively committed to producing a total of of certain land deals that were entered into between the previous government 500,000 subsidized units of newly constructed houses between 2005 and 2011, an and developers. The current government has indicted its willingness to average of 85,000 subsidized units annually, for rental, leasing and ownership. protect investors but no concrete solution has yet been put forward as to how The armed forces and Ministry of Interior have built additional public housing for or when this will be accomplished. Analysts believe that cancellations will their personnel. The largest portion of subsidized housing has traditionally been become more numerous (estimated cancellations for 2011 are 10–15 percent produced by government entities such as local government and governorates, of contracts) which would have serious repercussions on the cash flow of some housing cooperatives, in new urban communities under the NUCA, and smaller developers, particularly those who are reliant on this form of funding.22 projects by government housing companies including the joint projects agency, the housing fund, the housing bank, and ‘Tameer’ agencies. Under the NHP, Housing Supply Constraints private developers have, for the first time played a substantial role and have The majority of Egypt’s housing stock is still constrained by very high committed to allocate approximately 95,000 units of the planned 500,000 units vacancy rates, rent control, and informality. Almost 3.7 million urban housing to be brought to the market and for which it will assume the market risk. An units are unused, either vacant or closed. The scale of vacant urban housing additional 100,000 units will have been produced by individuals under the “Ibni units, much more serious than in other emerging markets, is a unique and Beitak” or site and service component of the NHP where individuals were offered puzzling phenomenon of the Egyptian housing market. One explanation is 150m2 plots with a subsidy to build their own property. that the sustained rapid appreciation in property values over the past 25 years and the lack of alternative investment mechanisms until quite recently Affordable Mortgage Finance Program meant that housing and real estate have consistently served as an inflation- The Affordable Mortgage Finance Program, which is supported by USD proof savings and investment tool, without need of the rental yield.23 The 300 million World Bank loan, is intended to expand the residential mortgage idea of renting was even less attractive due to the imposition of rent control market and increase access to mortgage loans for low and middle-income until 1996. Even now, the continued perception of uncertainty about the households in order to improve housing affordability. Its focus is on those enforceability of the new rental law makes many owners hesitant to put their households falling within the 75th to 45th percentile of the urban income unoccupied units up for rent. Poor targeting of government subsidized units, distribution band with the ultimate goal of gradually making the bulk of these and unattractive locations of subsidized units in New Urban Communities, subsidies available to the lower income range of the band. It will encompass have further exacerbated the problem. new and existing housing and new and older urban areas to offer a wider range An estimated 42 percent of the housing stock is frozen under rent of housing options and prices. Lower income households, that fall below the control. Since the passage of Law 4 of 1996, which allowed newly built units to 45th percentile and who would not otherwise have access to mortgage credit, be placed on the rental market with the exception of existing rent-controlled will benefit from low-cost rental housing programs and “infrastructure only” units which were grandfathered for the duration of the then existing rental programs planned for the same period. agreement, the rental market is showing signs of increased dynamism. Linking the program to mortgage credit will leverage substantial private However, the TAPRII Greater Cairo Housing Demand Survey found that sector resources for housing and free up government resources for lower income 42 percent of the total urban housing units in Greater Cairo remain locked housing. The program will leverage financial market and household resources under the rent control regime due to the grandfathering provision, and for housing, and alleviate pressure on the government to substantially subsidize that this situation does not appear to be benefiting the poor. Excluding much of the housing supply for middle-income households. The new program such a large proportion of units from the rental market greatly constrains will decrease the total and per unit housing subsidy burden. It also intends to residential mobility, significantly reduces the inventory of rentable property, improve the targeting and efficiency of subsidies by linking subsidies to affordable and distorts the overall housing market. mortgage loans that beneficiaries are required to take out with a participating Some 45 percent of new urban housing is produced by the informal lender of their choice. Households are required to pay a down payment. Typically, sector. During the period (1996–2006), the urban housing stock is the subsidy will be paid out over the initial years of the loan in the form of a conservatively thought to have grown by an annual average of 2.8 percent or contribution to monthly mortgage payments on a maximum affordable loan.The 263,838 units.24 Of these, 55.6 percent were formal and 45.4 percent informal program of mortgage subsidies is administered through the Mortgage Finance (built without government authorization and registration). Constrained by Fund, formerly the GSF. It is anticipated that as many as 65,000 loans annually onerous building and zoning standards, as well as a bureaucratic and costly would be done under the program. permit issuance process, many small developers operate within the informal 144 Financial Development and Inclusive Growth Non-Bank Financial Institutions 145 sector to meet the growing housing demand of lower income households. Property Registration Rate While informal housing provides a low cost housing solution, it undermines Conversion of the land and property registration arrangement in urban planned provision of infrastructure and does not allow households to use areas from the Sejel Shakhsee (person-based deed registration) system to the mortgage finance, which hampers their affordability. Sejel Ainee (title registration) system through effort coordinated/overseen by While these distortions are not entirely additive (e.g. an informally the Ministry of State for Administrative Development and involved cooperation built unit may be kept vacant), it could be conservatively estimated that 50– between the Ministry of Justice’s Real Estate Publicity Department (REPD) and 75 percent of the urban housing market in Egypt suffers from such market the Ministry of Irrigation and Water Resources’ Egyptian Survey Authority (ESA). constraints. These combined market weaknesses directly affect adversely Historically mortgage finance has been constrained by a deficient the housing affordability, the potential for success of the recently initiated property registration system. Few titles have been registered in the past, in mortgage system, labor mobility (economic growth), and the government’s large part due to the high cost and time-consuming registration process. This ability to address the shelter needs of poor households. has led to the growth of informal housing, slower economic growth, weakened social protections, and reduced collection of fiscal revenues. Except for mortgage Developer Financing Model credit applications, in Egypt the registration of property is not mandatory for a One of the recent successes in Egypt’s housing market has been the legally enforceable real estate transaction. In recent years, the cost of deed or growth in private housing development. Many of the companies set up to title registration has been lowered and is no longer tied to the property value develop the New Urban Communities have seen rapid expansion thanks to but charged at a maximum flat fee of LE 2,000. In addition, a special agreement large land banks and a comparative rise in demand from a wealthier middle has been made between the Ministry of Administrative Developemnt and the class. However, this expansion in housing has occurred despite the mortgage Ministry of Investment to fast track the registration of new housing in priority system rather than as a result of it. Some estimates put the number of zones under the NUCA. However, registration of existing units in older urban mortgages as low as 1 in a hundred new properties. areas will continue to be time-consuming, particularly for multifamily housing The developer installment loan-financing model is a response by the units. The registration of the large stock of informal housing on agricultural developer to the lack of formal financing provided by the financial sector. The land is to be resolved by requiring approval of the current building and planning schemes are more akin to a leasing arrangement than a typical mortgage standards of the area, which will be greatly facilitated by the new Building loan, with much greater protection for the seller, which in this example is Law 119 of 2008. Only then, can individual units be registered. the developer.Because the property is only transferred to the purchaser upon receipt of the final payment, the developer is in an advantageous position Obstacles to Further Development of Egypt’s Mortgage Market should any problems arise with respect to making payments. There is no Egypt’s mortgage market has made great strides over the past decade need to foreclose on the property as the developer is still the owner. Also putting in place much of the necessary infrastructure to facilitate growth in this model, there is potential for no equity to have been built up as the and expand access to lower income groups. However, despite policy work that transfer is dependent on the final payment being made. Any default could has already been carried out and the creation of new entities such as the mean losing all previous payments, unlike a mortgage where a portion of the EMRC, the mortgage market accounts for less than 0.5 percent of GDP. This principal would have been paid down. chapter will explore some of the reasons underlying the mortgage market’s In practice developers in Egypt, have contracts, which provide consumers underdevelopment and considers the steps that might be taken to meet with a good degree of protection, and there is recognition of some principal current needs by expanding housing investment. down payment, and even interest paid on deposit balances. However, this Property registration. The inadequacies of the current registration may not be the case with all developers, as this type of financing is entirely process remains the fundamental obstacle to achieving a secured lending unregulated and varies greatly.The buyer will typically put a deposit down system based on property. The time it takes to register property and the on the property ahead of its construction and gradually make payments in related uncertainties that exist during the registration process, create a major line with progress on the property and then continue making payments for impediment to the development of mortgage lending. This was identified long several years after delivery. Developers are able to offer loans for as long as ago and multiple efforts by Ministry of Administrative Developemnt, USAID 7 years now. The process does include many safeguards and is transparent. and the World Bank have yet to produce a system which is reliable and where However, it is not regulated by any government or industry body and could delays are minimized. be open to abuse by less scrupulous developers. Equally, the consumer could Developer financing of buyers. The vast majority of newly built properties fall victim to the financial collapse of the developer and never receive the in Egypt are purchased either for cash or pursuant to an installment loan system final transfer of the property at the end of the installment period. provided by the real estate developer. This system presents numerous problems: 146 Financial Development and Inclusive Growth Non-Bank Financial Institutions 147 ϘϘ A potential conflict of interest arises in circumstances where a shareholder equity, has thus far proven sufficient to meet most of the needs developer also provides financing to the end user. The sale may be of a market with such limited growth. High interest rates have also made it tied to the financial product being offered, and this in turn may result difficult for EMRC to raise funds through bond issuance at rates that it could in the consumer obtain an inferior deal. pass on to banks at a competitive level. A sustainable economic and reliable ϘϘ Some installment products can be quite profitable for real estate source of funding is needed for the long-term development of the market. developers and may act as an incentive to delay the subdivision of Dysfunctional retail deposits market. A major impediment to the their plots into individual titles thereby making mortgages impossible development of an economic funding solution for MFCs and banks is the to secure until the whole development is complete. serious flaws that exist in the Egyptian deposit market. Deposits are largely ϘϘ Installment loans weaken the borrower’s position in situations where price inelastic, which means that even during periods of soaring inflation, or they obtain no ownership interest in the property until the final rising interest rates, depositors do not shift their deposits including times payment on the installment loan is accepted. As such, until the final where they are receiving negative real rates of interest. This is in part due payment is accepted there is the theoretical possibility that should to a lack of competition among financial institutions, large public sector the borrower default, they will also forfeit any rights in the property deposits that do not necessarily behave in an economically rational manner and lose all payments previously made regardless of how much and a regulatory framework, which allows deposits to fund a large part of has already been paid. In practice, the contracts, which are signed lending. Within such an environment, it is difficult for EMRC or indeed other with the larger developers, actually include provisions to address to capital market funding mechanisms to compete with much less expensive ensure that the consumer is reasonably protected, but this may not deposit based funding. be the case with all developers. Inefficiencies in the housing market. Typically healthy mortgage ϘϘ The position of the consumer is also weaker in cases where the markets go hand in hand with thriving and liquid housing markets. A key developer becomes bankrupt and creditors may take a different view feature of such a market would be an active resale market, not just a market of borrowers in default. Another situation relates to the current land for new properties. This has yet to fully develop in Egypt for a variety of declamations by government in cases of deemed fraudulent sales. A reasons including: The substantial stock of vacant properties that are held purchaser of a property on an installment sale would certainly be as investments given the absence of other investment opportunities; the subject to much less legal protection than in cases where they have lack of organized primary or secondary property markets; the lack of proper full title to their property. incentives in the rental market which could make it more attractive and safer to rent out properties for property owners; and the lack of regulatory ϘϘ Installment schemes often involve down payments for off-plan sales. oversight or strategic direction for the sector. Banks were forbidden from providing financing to consumers for pre- sales, which induced developers to provide their own alternative. During the initial phase of Egypt’s mortgage market development, a These pre-sales form a significant part of the developers’ project key role was performed by the MFA and the Ministry of Investment. Both finance. The obvious danger in this arrangement is that these schemes have now been disbanded leaving no comparable ‘champions’ to promote the are wholly unregulated and as has occurred in many countries, the further development of the mortgage market. EFSA has undergone significant failure of a developer can result in many property buyers losing their structural modifications as well as numerous personnel changes which have deposits. Frequently the deposit represents a buyer’s life savings and adversely affected its ability to fully deliver on its mandate. In addition, once lost, with it goes any hope of becoming homeowner. there is a significant shortage of experienced staff possessing the requisite skill sets to effectively carry out routine supervision duties for the mortgage ϘϘ Another problem with installment loan schemes is the lack of sector. EFSA is not charged with the same strategic market development role sustainability. There is a limit to how much funding the developers that MFA had under the auspices of the Ministry of Investment. are able to raise. The loans also cannot be easily securitized or funded through a secondary mortgage market mechanism. They are clearly a second best alternative and a potentially risky one also. Financial Leasing and Factoring Funding of mortgages. This has been an ongoing issue which the Introduction: Why Leasing? creation of EMRC was intended to address. To date EMRC has succeeded in refinancing a significant portion of existing loans, but has also not yet been able Financial leasing can play a key role in the development of financial to create a bridge between the capital markets and the housing market. The markets. While on the one hand, the industry complements the banking World Bank loan that provided the initial funding for EMRC, together with sector by increasing the range of products and services provided to potential 148 Financial Development and Inclusive Growth Non-Bank Financial Institutions 149 clients, on the other it increases the competitiveness of the financial sector purposes, a practice which had previously been restricted by the Ministry as a whole by competing with banks and forcing them to improve efficiency of Tourism to companies with a tourism license.26 To date, only Financial and responsiveness to clients. Leasing also plays an important role in Leasing is permitted under the current law. enhancing access to finance for younger and smaller enterprises that often Despite the industry’s relative cumulative growth and the favorable face sometimes insurmountable challenges in obtaining credit from banks. developments in the market, leasing remains relatively small and By retaining ownership of the leased assets, the lessors have the ability to underutilized in Egypt. The most recent EFSA Annual Report on the industry recover their investment in case of default with greater ease, which in turn estimates the size of the market at LE 6 billion, which is less than one percent lowers the overall risk and makes smaller enterprises more viable clients. of GDP.27 The most recent enterprise survey data available for Egypt shows As such, for SMEs that do not have a lengthy credit history or a significant that the enterprises sampled lease or rent only 18 percent of their land and enough asset base for use as collateral, leasing can play a critical role in 17 percent of their buildings.28 bridging the SME finance gap and bringing small businesses into the formal Although in the past five years the number of leasing contracts has financial sector. As opposed to other financial instruments, leasing, being remained relatively constant, the total value of contracts has tripled in sized an asset-base financing option, also has the added advantage of being an (Figure 4.11). This is largely due to a growth rate of almost 140 percent inherently Shari’a friendly product, which makes it an attractive financial between 2009 and 2010. The most recent figures for the year 2011 show a option for enterprises in Egypt with an appetite for Islamic finance.25 significantly lower growth rate of only 2.3 percent, which is most likely due Figure 4.10: Growth of the Leasing Industry to the post-revolution economic uncertainty. 10000 Figure 4.11: Leasing Company Market Share for Q4 of 2011- Growth of the Leasing Industry 8000 6000 17% 21% 4000 14% 2000 20% 10% 0 7% 8% 3% 2009 2010 2011 2012 2013 leasing # of loans value of loans (milion EGP) Source: EFSA. Sogelease Egypt Al-Tawfiq Incolease Orix Egypt BNP Paribas Other Technolease Corplease The Egyptian Leasing Industry Source: Ministry of Investment. The Egyptian leasing industry was established by Law 95 of 1995 and later amended by Law 16 of 2001. Among the most important features of Although there are currently 208 leasing companies registered with the amendments was an increase in the minimum capital requirement for EFSA, only 24 of them registered leasing contracts in 2011.29 Of these 24 leasing companies as well as major changes in the manner in which leasing companies, approximately nine have been active in the market and make transactions are taxed. up most of the industry’s market share. These companies are for the most part, owned by banks or bank-affiliates. While figures from the most recent The laws and amendments governing leasing in Egypt allow for the quarter show that Corplease and Sogilease were among the most active and commercial leasing of all types of assets including cars–which under the had a market share of 21 percent, and 17 percent respectively for the final initial law had not been permitted–as well as the leasing of land attached quarter of 2011, cumulatively, Incolease is the largest player in the market to productive activities. A Ministerial Decree issued in 2005 opened yet with approximately a 30 percent market share.30 another business line allowing leasing companies to lease buses for touristic 150 Financial Development and Inclusive Growth Non-Bank Financial Institutions 151 In terms of activities and sectors financed by the leasing industry, assets by type or activity, number of active leasing companies and leasing buildings and real estate, aircraft, and boats/ships, and automobiles, are the companies’ market share. It also produces an annual report that features sectors most often financed with 40 percent, 18 percent and 12 percent of all the aggregate data for the year as a whole. While all this work represents a leasing contracts for 2011 respectively (Figure 4.12).31 positive first step for EFSA, there is still potential for it to play a much larger Aircraft leasing has tremendous growth potential in Egypt. The MENA role collecting information, promoting the industry and proposing changes to region is currently witnessing one of the highest growth trends of this sector the leasing law necessary to support the industry’s growth. especially in the booming area of commercial low-cost carriers (LLCs).32 Airlines are increasingly making use of leasing as a financing tool instead of having to rely on more conventional finance sources. Box 4.1: The Egyptian Leasing Association Figure 4.12: Value of Leasing Contracts The Egyptian Leasing Association (ELA) is a not-for-profit professional trade association established in 2011 with the main objective of being the voice, promoter and advocate of the leasing industry in Egypt. The ELA was founded by the majority of active leasing companies in Egypt including Adilease, Al Tawfeek, Corplease, Orix, Piraeous Leasing, Soglease, Incolease as well as a 3042 number of individual leasing experts. Among the association’s strategic objectives are (i) creating awareness and 6084 educating investors/lessees and other stakeholders about leasing and ijarah and 1239 their benefits; (ii) creating a physical space where players can discuss impediments that are faced by leasing companies and ways to overcome them; (iii) developing 686 training courses to enhance the technical expertise of leasing professionals; (iv) proving networking and business opportunities; (v) fostering ethical standards, 458 best practices and corporate governance in the leasing industry; and (vi) being 317 a source of information about the leasing and ijarah industry through periodic 216 17 110 online newsletters and publications on the industry. Sector Real Estate Automobiles Medical Equip. Heavy Equip. ELA offers its members several benefits which include an enhanced corporate Production Lines Photocopiers & Faxes Aircrafts & Ships Other profile through local and international networking among leasing practitioners Source: EFSA. worldwide, a forum for interaction with stakeholders, policymakers and regulators, advisory services to member of policy compliance and market intelligence and the dissemination of vital information on leasing trends and Recent Development in the Leasing Industry developments in the industry. Three key developments have recently taken place that have positively ELA has been meeting regularly with EFSA to discuss a number of constraints affected the institutional and regulatory environment in which the leasing facing the industry and a short policy paper has been issued that not only industry as a whole operates—the first and most significant is the change describes these constraints but also suggests a number of legal amendments that in regulator. When the leasing industry was first created, the companies will, in both the short and long term, be of tremendous support to the growth of established reported to the General Authority for Free Zones and Investment the industry. (GAFI), which acted as its administrator. Today, leasing is regulated by EFSA, the consolidated regulatory body for the non-bank financial sector established in 2009 by Law 10 of 2009. While In March 2008, the first private credit bureau, I-Score, became no significant changes from the previous regulatory regime have taken place, operational. I-Score has a database of approximately two million borrowers, leasing companies have witnessed an improvement in the streamlining of the which includes both individuals and SMEs, collected from several sources registration process. In this regard, the registration of all leasing contracts including the public credit registry, banks and NBFIs. Credit reports has now been computerized and the approval of contracts can be completed are updated on a monthly basis and provide comprehensive and reliable online.33 Based on the formal reporting required of leasing companies, EFSA information services including the manner of payment, the length of has also begun producing quarterly reports which contain industry data outstanding loans, the history of loan balances and repayments.34 While, including value of total leased assets, number of leasing contracts, leasing the establishment of I-Score has helped the financial sector as a whole by 152 Financial Development and Inclusive Growth Non-Bank Financial Institutions 153 improving access to creditworthiness information, the establishment of higher default rates and an increase in the cost of doing business. A stronger a unified movable collateral registry as part of I-Score will be particularly judicial system, which is able to enforce foreclosures and ensure the efficient beneficial to the leasing industry by reducing risk in contract leasing and and effective repossession of assets in case of default, is key to developing increasing confidence of lessors in contracts and SMEs. a supportive regulatory environment for leasing. While the establishment The third major development for the leasing industry in Egypt was and development of economic courts is a step in the right direction, greater the establishment of a professional leasing association for the industry. The capacity building of these courts and the training of judges–especially in Egyptian Leasing Association (ELA) was established in 2011 to act as a voice leasing concepts - is necessary for greater overall effectiveness. for the industry and includes all the major players in the market (see Box 1). The growth of the industry is also constrained by legal obstacles that Not only does the existence of an association allow the leasing industry to create unfair disadvantages to leasing and create unnecessary barriers have greater visibility in the market and attract a greater number of clients, to the expansion of the sector. There is a great deal of confusion in the tax but it also allows for the industry to be a united advocacy group with the and accounting treatment of leasing as well as a general inconsistency with lobbying power to bring about necessary legal, regulatory and institutional international standards. The existing fiscal legislation treats financial leasing changes for the industry. as a type of rent, not a form of financing, and hence, does not create a level playing field between leasing and other forms of credit. The definition of Constraints to the Growth of the Leasing Industry and Recommendations leasing in the law must be adjusted to contain a clearer, more precise definition There remain several constraints facing the leasing industry that that differentiates this type of financial transaction from all others including have inhibiting its growth and it ability to achieve its full potential. Of property hire or rent to prevent abuses of tax benefits and double taxation. these inhibiting factors perhaps the most crucial is the scarcity of long-term In order to increase the industry’s client base, it would also be of great funding. Leasing companies tend to rely on their sponsor bank for funding. benefit for the law to be amended to allow for leasing for non-commercial This is a problem for a variety of reasons: (i) although most are, not all leasing purposes. The leasing industry in Egypt is also in need of a sounder institutional companies, are owned by banks or bank-affiliates and as such will not have environment to operate within, particularly through the establishment and the same access to bank funding; (ii) even when the long-term funding from development of more effective registry procedures. The absence of a registry banks is made available it is prohibitively expensive; and (iii) banks are the for leased assets increases the risk to the lessor and hinders the expansion main source of competition to leasing companies and increased borrowing will of the market. The law in Egypt currently imposes requirements to register lead to increases in the companies’ leverage. Moreover, the relatively limited individual leasing contracts instead of the asset themselves. This is not only development of capital markets does not support the issuance of bonds to a cumbersome procedure for the lessor, but it also inhibits the development provide long-term funding. Despite this, it is worth noting that in 2009 and of a secondary market for moveable assets. It is vitally important for the 2010, two leasing companies issued bonds that provided them with much industry that I-Score move forward with the establishment of its moveable greater flexibility in utilizing their funding and a better matching of finance assets registry. tools. Bond issuances in 2009 amounted to LE 2 million in 2009 and LE 6 Finally, one of the reasons the industry is not achieving its true potential million. There were also securitization deals worth approximately LE 538 is the lack of understanding of the sector and the limited information and data million.35 While this was an important step for these companies in an effort to available on it. There is a lack of experience, skills and understanding of the enter the debt market, these amounts are still quite limited when compared sector by current practitioners and potential lessors as well as a general lack of to the size of the industry as a whole and the need and demand for long-term awareness on the part of government officials including agencies responsible financing. In order for the leasing industry to access the amount of long term for asset registration, courts, and the tax authority. Both EFSA and the funding needed to grow exponentially, the bond and asset-backed securities Egyptian Leasing Association have an important role to play in creating both markets need to be further developed in order to extend the average maturity a greater understanding as well as greater visibility for the industry. While of leasing contracts and better serve potential and existing clients. the quarterly reports issued by EFSA are helpful and a positive step forward, Another main challenge facing the leasing industry is the difficulty the data available remains to be limited with only a few specific indicators of repossessing assets associated with the inadequate enforcement of being tracked on a regular basis and on an aggregate and cumulative level. ownership rights and the delays in the collection of overdue payments. Due Producing reports and disseminating information on the sector should be one to the difficulties of repossession and the poorly developed secondary market, of the Egyptian Leasing Associations main objectives.36 leasing companies are often forced to resort to negotiations with customers Although the industry has not grown as much as it has the potential and rescheduling of leases. Cumbersome repossession procedures also to, especially in the past year, the circumstances surrounding the transition increase the credit and liquidity risks for lessors, which ultimately leads to period in Egypt can be extremely advantageous to the industry. Due to the 154 Financial Development and Inclusive Growth Non-Bank Financial Institutions 155 government’s increased domestic borrowing to reduce the fiscal deficit and From an institutional perspective, there are three main types of the associated crowding out of the private sector, it will become increasingly constraints applicable to all segments: (i) large pockets of unregulated difficult for banks to extend loans, especially to start-ups and SMEs. These businesses such as housing finance by developers, health insurance and exceptional circumstances provide an opportunity for this vital and vibrant private pension fund schemes; (ii) regulatory or institutional gaps such as industry to play an important role and serve a sector that is the backbone of the lack of a moveable property registry or the inefficient application of the Egyptian economy and a major source of employment. existing regulations (e.g. land and property registration); and (iii) insufficient Factoring: as of end of 2013, there are 6 factoring companies licensed institutional support for EFSA to enforce existing regulations and lead by EFSA. Total financing provided throughout that year reached EGP 3 effectively initiated reforms. In this context, a stronger support to EFSA to billion, outstanding balances at end of December 2013 were EGP 0.9 billion. develop the required strategic plans within each sector would be essential to resume, and re-design, to the extent needed, reform plans initiated before the revolution. Concluding Remarks NBFIs services have made relevant progress after Phase I (2004–2008) and Phase II (2009–2012) of the Financial Sector Reform Program, but are still well below their potential in Egypt’s economy. As experienced in other countries they are essential for financial deepening, access and competition. Particularly insurance, pensions and efficient mortgage markets are important to channel savings to productive investments, as well as to build the social safety net required in Egypt. Leasing services are also critical to facilitate access to finance to new and small firms. Reforms conducted over the last eight years include a reduced presence of the State and the development of institutional and regulatory frameworks supportive of a greater presence of the private sector, particularly, in the insurance, housing and leasing sectors. The consolidation of the different regulatory bodies into the EFSA was a landmark with promising prospects both for enhanced regulation and for a well-articulated development plan across all capital markets and NBFI services. Several institutional and legal reforms supportive of growth across all sectors were also initiated. A sample of these reforms include the res-structuring of loss making state- owned insurers the creation of mortgage finance companies, reforming the land and property registration system, a unified building code, enforcement of foreclosure regulations and the constitution of a first private credit bureau. The latter benefited also the leasing activity. Most of the momentum achieved with these reforms came to a halt with the revolution, but no clear regression has been experienced so far. Main challenges ahead may be divided between structural and institutional obstacles. From a structural point of view, besides the need of a stable macroeconomic framework, one of the main obstacles is the dominance of the banking sector and the low level of development of capital markets. Instruments available to insurance and pension funds with long-term investment horizons are limited to government debt and bank deposits. On the funding side, mortgage and leasing financing is relatively short term not exceeding 5–7 and 7-10 years, respectively. In addition, each sector has specific structural constraints such as a shallow secondary housing and rental market, or a still too large workforce in the public sector in the case of pensions. 156 Financial Development and Inclusive Growth Non-Bank Financial Institutions 157 Endnotes 35 Rashad, Shahinaz. “Egypt Market Review” Euromoney World Leasing Yearbook. (2011). 36 It is worth noting that IFC is currently undertaking a Market Assessment Study of the leasing industry 1 The state-owned insurers held most of the controlled rent properties in Cairo. However some strategic (focusing on tax and accounting aspects, regulatory framework and lessors’ current operations) which shareholdings and commercial properties were heavily undervalued in the SOI’s books. should identify the impediments facing the development of the leasing industry and the most critical areas 2 The relative managerial performance can be seen on the 2004/5 expense rates. Misr was less than 20 percent that need to be addressed (either on tax/accounting/regulatory or capacity building/awareness fronts). A while the other two direct insurers were both over 30 percent. Despite being smaller than Misr, Al Chark comprehensive report including findings and recommendations will be developed and a policy paper with had more staff. recommendations will presented to EFSA. 3 The combined ratio is the sum of the claims ratio and the expense ratio. 4 Actual solvency divided by required solvency. 5 Total MTPL technical provision strengthening for Misr Insurance over the 2006/2011 period amounted to LE2.3 billion of which 700 million was added in 2009/11. Misr Life strengthened life mathematical reserves by LE 200 million in 2010/11 of which 50 percent was funded by IHC and 50 percent from general reserves. 6 The major ongoing sources of profit for Misr Insurance have been the transport (mainly marine and aviation) and industrial sectors (engineering and oil and gas). 7 The IMF defines Fiscal Space as ‘room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy. 8 Required to fund the run off of the previous system’s obligations. 9 The actual allocation will be determined under the Executive Regulations in order to ensure flexibility. 10 Hospital bed occupancy rates are on average only 40 percent nationally. 11 Approximately 50 percent of the population is uninsured. 12 The Ministry of Health would effectively become a buyer of rather than an operator of health services. 13 The military and senior officials have preferential access to a separate system. 14 There are already approximately as many private primary and secondary health care providers as there are ‘free’ facilities under the Ministry of Health. A large number of primary care facilities (mainly school clinics) are also provided to formal sector workers through the government Health Insurance Organization (HIO). 15 For example the largest and original Takaful non-life insurer has been prepared to underwrite tobacco risks. 16 Facultative reinsurance sessions are made on an ad hoc basis and priced at the time of placement. 17 Hernando de Soto, Op-ed: Egypt’s Economic Apartheid, The Wall Street Journal, 3 February 2011. 18 Drawn from Affordable Mortgage Finance Program Project Appraisal Document (2009) and Affordable Mortgage Finance in Egypt: Challenges and Prospects by Sahar Nasr, 2010. 19 Beck and Honohan (2004). 20 Source: StatCompiler website which summarizes household surveys from around the world, www. measuredhs.com 21 Source of data and estimates - Talaat Mustafa Group investor presentation June 2011. 22 Source Deutsche Bank, Egypt Real Estate, 9 August 2011. 23 Despite some slowdown in the early 2000s, this trend has continued unabated and has very recently reached new heights, fuelled by major inflows of foreign investment in real estate in Egypt from regional investors. 24 The preliminary results of the 2006 census made available by CAPMAS do not allow for a precise calculation of the number of housing units. As such, the total number of housing units in urban areas was inferred as the sum of “apartment units” (shakka) and “one/more independent rooms” (hogra mostakela). This figure is counter-balanced by the exclusion of single family housing and the failure to account for housing units converted into offices. 25 Al-Sugheyer and Sultanov. Leasing in the Middle East and Northern African (MENA) Region: A Preliminary Assessment, 2010. 26 World Bank, Access to Finance and Economic Growth in Egypt, (2008). 27 GDP for FY 2011 is 1.3 trillion as per the Central Bank of Egypt Monthly Bulletin. Leasing is approximately 0.6 percent of GDP. 28 Egypt Enterprise Survey Data, 2008. From the leasing data available, it is assumed that the larger bulk of this percentage is made up of rented as opposed to leased land and buildings. 29 EFSA Annual Report, 2011. Many companies will establish a subsidiary company to conduct a single leasing contract to take advantage of the tax benefit for a specific transaction. 30 Egyptian Leasing Association Estimate. 31 EFSA Annual Report, (2011). 32 Rashad, Shahinaz. “Egypt Market Review” Euromoney World Leasing Yearbook. (2011). 33 Ibid. 34 Project Appraisal Document for the Second Financial Sector Development Policy Loan, 2008. 158 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 159 5. Financial Sector Integrity and Economic Growth Introduction The development of financial intermediation plays an important role in a market economy supporting the optimal allocation of resources, contemporaneously and inter-temporally, and thereby determining potential output and its broad- based growth. Confidence in contracts and soundness of institutions and market processes that define financial intermediation are of course key to its development. Furthermore, the broader the range of financial products and their access to them, the greater the contribution of financial intermediation to economic growth is. Soundness and access are in fact interdependent factors in the growth maximizing development of financial intermediation. Moreover, a strong regulatory and supervisory framework for their full achievement must underpin both. This perspective forms the basis for the assessment in this Chapter of the progress with financial intermediation in Egypt, looking successively at bank and non-bank financial intermediation. A main objective is to identify gaps and weaknesses in the current regulatory and supervisory framework that constrain its development, and to propose remedial actions. The Chapter highlights the fact that despite significant progress with reforms during the past decade, gaps and weaknesses remain. Largely as a result, confidence and soundness is still wanting, while the scope of financial services and access to finance is still limited in certain areas, in particular housing, SMEs, and the corporate securities market. Changes in the legal and regulatory framework, and measures to further strengthen the CBE and EFSA’s ability to effectively implement supervision in an expanding and diversifying financial system are proposed. 160 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 161 Banking Supervision With respect to (1), there is a need to include in the banks’ quarterly Egypt’s financial sector, and its banking system in particular, has reporting requirements information on the structure and concentration undergone profound changes since the early 2000s, yet continues to lag of the bank’s shareholders, and on the loan concentrations reflecting the other countries and regions in a number of indicators measuring its citizens’ largest borrowers, given the relevance of this information to the incentives access to financial services. As a result of the implementation of an ambitious for enhancing access to finance. Furthermore, the increased significance financial sector reform program, the banking sector has emerged as more of brokerage, mortgage finance, and financial leasing subsidiaries and efficient and transparent, financially sounder, and better equipped to manage affiliates, has required all listed banks to move to quarterly reporting of their the risks inherent to its activities. It has also expanded into many business consolidated operations as well. lines that were poorly developed a decade ago, in particular consumer lending With respect to (2), many of the weaknesses in the legal framework and asset management. and its enforcement, such as the lack of real estate title registration, are A main purpose of this Section is to look at the interface between entrenched and long standing, and call for greater flexibility and novel access to finance and the regulatory and supervisory environment as broadly approaches, such as a “register-able” property mortgage finance based on an understood, with a view to improving this environment to facilitate greater “interim” real estate title registration which could form the base for mortgage access. Development of the financial infrastructure is a major enabler in collateral and its registry. Another significant gap with secured transactions this regard, and gaps in this infrastructure may severely impede access. to be addressed is the lack of a legal and regulatory framework for the use and While soundness mostly motivates banking regulations, their existence registration of a broad range of movable property collateral. Furthermore, the and effectiveness may also broaden access to finance by clearly codifying existing bankruptcy procedures continue to focus exclusively on liquidation, the conditions under which such access is indeed possible on a financially and need amending. sound basis. At the same time, some regulations may unintentionally and With respect to (3), good corporate governance and financial disclosure unnecessarily impede access as well. In this context, the paper highlights gaps enhances market discipline and efficiency, and promotes an incentives and weaknesses in the banking infrastructure and regulatory environment structure that encourages diversified lending. In this regard, CBE’s regulation that continue to make access to finance difficult in certain cases, and proposes states that the majority of a bank’s Board members and its Chairman must measures that may remedy them. be Non-Executive Directors. There is a requirement to have separate Risk There is clearly a potential tension between broader access to finance Management and Audit committees by law. There is greater conformity and financial soundness. Expanding access to finance means dealing with between CBE and EGX governance and disclosure requirements, which initially less familiar customers lacking a track record of financial dealings, encourage banks to list. In addition, the CBE should develop incentives that and thus taking more risk. Nevertheless, as long as the latter is properly influence banks to seek an international credit rating, for instance by making priced, and carefully managed, soundness need not be affected; and improving it a condition for banks to undertake certain types of borrowing. Despite the information on and governance of these customers will help limiting that significant progress in recent years, more efforts should be exerted for the greater risk as well. Furthermore, because expanding access can also lead to effectiveness of good corporate governance at the state-owned banks. The greater portfolio diversification and a reduction in the concentration of risks, fragmentation of the ownership function and the continued dominance of it can ultimately also contribute to the overall financial stability of a bank. management at these banks need to be further addressed. Generally, there is In any case, a strong risk-based banking supervision is a critical prerequisite still significant room for improvements in the amount, quality, and frequency for expansion and diversification of bank financial intermediation. of public disclosure of financial information by banks. Sub-section A offers a macro-view of Egypt’s banking system, With respect to (4), Egypt has made significant progress with regard highlighting the structure of its assets and liabilities, and how it has been to the availability of reliable credit information, a key requirement for shaped by various factors, especially, the large contribution of the banking facilitating greater access to finance. The obligation to obtain an I-Score sector to financing of the government, but also gaps and weaknesses in the report before a bank can extend credit has been extended to other financial financial regulatory framework and infrastructure. institutions as well. Furthermore, one priority should be to ensure that the Sub-section B reviews the progress and challenges with the implementation fees of the credit bureau do not discourage microfinance institutions from of the broader regulatory framework for financial and banking transactions, becoming members of I-Score and using its credit information, and some form centering on (1) reliable financial reporting and auditing; (2) well designed and of fee subsidy could be considered. Two priorities, with possible involvement enforceable secured transaction rules; (3) progress toward improving corporate of I-Score, are the creation of a central registry for movable collateral; and governance and financial disclosure; (4) the availability of reliable credit the creation of a SME rating agency, with possible government support to information; and (5) entry and exit rules that promote competition. mitigate the deterrent effect of rating fees. 162 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 163 With regard to (5), greater competition should incentivize the banks linkage between management of these exposures and progress with access to broaden their lending activities. In addition, the conditions for approval to finance. For instance, approval of new branches could, in part, depend on of new branches should give greater weight to the prospects for increasing the bank’s performance regarding large exposures. Furthermore, the system access to finance in the location being considered, for instance, by making the of loan classification, collateral, and provisioning must be reviewed from the local density of SMEs an important variable in the decision. Going forward, perspective of access to finance given that it affects banks’ credit decisions. ending the moratorium on new banks and promoting the market oriented With regard to (2), the difficulties with real estate title registration and behavior of state-owned banks, including through further privatizations, are associated costs and uncertainties have been a major concern for banks and priorities, as is the introduction of a full-fledged banking resolution regime. an impediment to lending. A flexible solution has been offered by the decree A uniform, limited, and funded deposit insurance scheme would not work due no 100 by the ministry of housing to facilitate this while not undermining to negative religious connotation.. prudential principles is a main pre-requisite for enhancing access to and Section C reports on the state of implementation of risk-based banking growth of housing finance. As mentioned earlier, standardized mortgage supervision, and deals with the challenges of supervision for enhanced access procedures under a “register-able” property regime; “interim” title and to finance. The latter necessitates that banks be able and willing to “move mortgage registration mechanisms as well as title or “quasi-title” insurance up the ladder” in terms of individual risk-taking, and risk-based supervision facilities; and review of the rules banning bank housing loans in the case of must accompany this development of financial intermediation. Specifically, informal and under construction properties, are all policy reforms that could the section first assesses the general progress with prudential regulations, prudentially facilitate broader access. The authorities should also undertake on-site inspection, off-site monitoring, loans classification and provisioning, a comprehensive comparative analysis of the differentiated regulatory capital adequacy, and sound liquidity management. Then it focuses on and supervisory environments for real estate mortgages between housing the interplay between prudential regulations and key concerns relating to finance companies and banks, with a view to eliminating distortion-induced access to finance, namely (1) encouraging diversification in bank lending; (2) inefficiencies, and incentives to engage in regulatory arbitrage. Furthermore, supporting housing finance; and (3) facilitating SME financing. the greater availability of mortgage credit guarantees or insurance should Generally, there is a need to further develop the capacities to assess encourage banks to offer more housing finance. Moreover, the issuance of market and operational risks, which will gain significance with the full covered bonds backed by mortgages or other assets would be a good substitute implementation of Basel II. the capacity to perform examinations of banking for mortgage securitization as a way to expand long-term funding sources for groups on a solo and consolidated basis is being addressed, specifically by housing finance. In this context, the current strict rules for public offerings strengthening and formalizing the exchange of information between the of bonds should be reviewed. CBE and EFSA. The stress-testing of banks will have to consider broader With regard to (3), there is strong evidence that the development of SME scenarios than downgrade of borrowers’ credit risk, to include interest rate financing has been hampered by the lack of comprehensive banking regulations and liquidity risks, especially as exposures broaden and Basel II comes specifically tailored to such lending. Three overarching factors must be into effect. The minimum 5 percent provisioning requirement for “watch examined: First, the broad regulatory infrastructure must be conducive to SME loans” should not be treated as a “general” provisioning, but as a “specific” lending. This calls for minimum accounting standards manageable for SMEs, provisioning, impacting on the CAR. The Macro-Prudential Unit may want credit bureaus specializing in SME assessment, efficient legal enforcement to broaden, in its analysis, the scope of potential structural imbalances and of creditor and borrower rights in the case of transactions with SMEs, and shocks that can affect financial stability. In addition, the CBE is disclosing specialized SME credit rating agencies. Second, prudential regulations cannot, regularly the NPLs ratio of banks (i.e. NPLs over total loans). Finally, there even unintentionally, be biased against the smaller enterprises. This calls for assesses the implications of both Basel II and Basel III for capital adequacy the banks to be allowed to take on exposures to SMEs based on a much broader of each individual bank, and at the aggregate. choice of possible collaterals. As already mentioned, this would require a new With regard to point (1) above, in the interplay between financial legal framework for movable collateral, supported by a centralized registry regulations and access to finance, limits to bank exposure to a single client for all types of collateral. Third, the banks must be provided an appropriate and to the parties related to the bank itself already encourage diversification incentive structure that encourages them to move into higher reward/risk and competition. By international standards, there is room for further lending opportunities. This can only be achieved through greater competition, tightening of the limits introduced in 2006. Large exposures to single clients based on market-oriented corporate governance. Further commercialization and should also be disclosed in quarterly financial statements, to enhance the the reduced dominance of state-owned banks is likely to be a key factor in this significance attached to these in the assessment of a bank’s soundness regard, which would also be facilitated by further privatization. Furthermore, and overall performance. Generally, there is a need to establish a stronger credit guarantees/ insurance should play a more important role in mitigating 164 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 165 the credit risk assumed by banks when they take exposures, especially longer A positive development in recent years has been the near halving in term, to more risky borrowers such as SMEs. In this context, the experience the share of bank financing of the SOEs, to no more than 7 percent of total elsewhere with private sector-led Financial Guarantor Funds should be studied lending and discounts, and, in contrast, the more than doubling in the share to see whether they could be replicated in Egypt. Local chambers of commerce/ of loans to the household sector, to almost 20 percent of total lending and business and professional associations could be especially well-equipped to discounts. This is higher than in China and Russia, though still less than half create such an entity. Finally, specific regulations governing the securitization the ratio typically observed among AEs and even some emerging economies of SME loan portfolios should be issued, with a view to enhancing the amount such as India. It appears to be the result of changes in the incentives of financial resources going to the sector. structure among banks that have encouraged greater portfolio diversification and upward movement along the risk-reward trade-off. These changes have Key Macro-Issues in Access to Finance been supported by key elements of the financial sector reform program, such Salient features of banking in Egypt. At about 40 percent of GDP, as the dramatic improvement in the infrastructure providing information bank lending to the business and household sectors is much lower than these on borrowers; the pressure on state-owned banks to adopt more profit sectors’ contribution to the deposit base of the banking system. The difference maximizing market behaviors;5 as well as banking supervision regulations largely reflects the significance of the banks’ holding of securities, especially specially tailored to consumer lending. Within loans to the household sector,6 government Treasury Bills (TBs), as a result of the banks’ contribution to however, mortgage finance for personal housing, whose legal basis had been the financing of sustained and large government deficits. That level of bank reset with the Mortgage Law of 2001, has remained extremely small, at no lending to the business and household sector places Egypt below the average more than 1 percent of total lending and discounts. This state of affairs has for many comparator countries and regions.1 In contrast, the household sector reflected continued difficulties with the registration of titles and mortgages. accounts for an unusually large share of deposits (3/4); the banking system Although rising modestly in the course of recent years, SME (defined has continued to be the principal recipient of household savings.2 3 as enterprises with turnover up LE 20 million) lending has remained Thus, the financing of government by the banking system has been a modest, amounting to less than 7 percent of total lending.7 This is below the significant source of “crowding-out” of the private sector’s access to finance. levels in many other countries where SME financing has been identified as Furthermore, the number of bank borrowers in Egypt by 1,000 adults (only a major problem, such as in China. Existing prudential regulations do not about 85) is well below many comparator countries and regions (200 on average appear to differentiate between SME and large enterprises financing, with in the MENA region, and 350 on average in emerging Asia), also evidencing an implicit regulatory bias toward lending to more established and larger the limited access to finance. Among those with access to bank credit, there firms. Recently though, a regulatory exemption has been granted to banks is still a significant concentration of loans, despite improving trends in recent to encourage SME lending. years. The attractiveness of TBs for banks reflects enticing risk-adjusted yield There are reports of a general lengthening of the maturities of both spreads between government securities and other assets, as well as the automatic assets and liabilities in recent years, as banks have moved into retail lending, eligibility of these securities for meeting the 20 percent statutory domestic with maturities above 1 year often more than 30 percent of total. Regarding liquidity ratio, as per CBE regulations. However, this statutory ratio has not been the maturity structure of deposits, the majority of deposits are short-term, a constraint in recent years. In short, despite the size of its banking system, there up to 1 year, but the banks also offer certificate of deposits of 3, 5, and even is no contradiction in stating that Egypt suffers from financial repression in terms 7 years. Reportedly, the banks generally try to match the maturity of their of its ability to meet the needs of its productive business and household sectors. loans with that of their deposits, with a view to limit the interest rate (re- The banks are often diversifying their financial activities through pricing) and liquidity risks. Long-term borrowing by banks has been limited, financial subsidiaries and affiliates. In turn, these may rely on bank given the difficulties associated with the issuance of asset-backed securities. loans rather than the financial market for their funding. Subsidiaries and The lack of a full-fledged local derivatives market would also limit affiliates include brokerage firms, housing finance companies, leasing finance the banks’ ability to manage maturity mismatches. A legal framework for companies, and asset management companies. A number of banks are still a financial derivatives market has been proposed by the EFSA, but awaits holding equity investments in non-financial companies that represent a large parliamentary approval. The banks’ financial statements do show, however, share of these companies’ capital. The low equity/assets ratio in conjunction that they use derivatives to some extent, including foreign exchange with the regulation that total investments (other than TBs and the trading forwards and interest rate swaps. There is little evidence that banks are book) cannot exceed 100 percent of capital4 severely restricts the allowable actively mitigating the credit risk, due to the lack of market-based credit level of investments in the banking book within total bank assets (to, guarantee or insurance facilities. The Credit Guarantee Company is the only basically, less than 7 percent in view of the prevailing equity/ assets ratio). known, and state-regulated, company providing guarantee mechanisms to 166 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 167 enable banks to extend credit to SMEs; it is largely funded by international Despite improving trends, capitalization of the Egyptian banking system donors. As of mid-2010, its portfolio of guarantees amounted to only LE 1.5 remains low by some standards, raising questions about the room for significant billion (0.3 percent of total lending, and an estimated only 4 percent of SME private sector credit expansion on its current basis. By 2010, more than 1/3 of lending), though involving almost 160 thousand micro-enterprises and SMEs all banks had a CAR greater than 20 percent. The current level of the CAR (reportedly, defaults did not exceed 4 percent). places Egypt at par with the average for the MENA and other regions of the While E-banking is widespread, there is currently no full legal framework world (with the exception of the Commonwealth of Independent States (CIS) to offer mobile phone banking.8 Guarantees, LCs, and other financial services are and Sub-Saharan Africa), which is a sharp improvement from Egypt’s standing also a significant part of the banks’ business. In addition, banks are very active at the beginning of the period under review. However, measured by the equity/ in offering money market and mutual funds, which they mostly distribute (for a assets ratio, the capitalization of the Egyptian banking system remains weak, fee) on behalf of non-bank financial entities. In some case, these are subsidiaries at still below 7 percent. This is significantly below that in most comparator or affiliates of the banks. Some banks also serve as conduit for the distribution of regions with the exception of developed economies (the ratio is typically 10–13 insurance products. percent among emerging markets), and reflects a more leveraged position. So far, the banks have played an only limited role in providing microfinance This under-capitalization has been made consistent with a reasonable lending. This market is dominated by NGOs and other specialized companies. risk-weighted CAR by the zero- risk weighting attached to the large portfolio Only two banks directly provide micro-financing, while two other banks support of government securities. This is despite the less than pristine rating of microfinance offered by other financial services companies. Banks in general are government securities by the international credit rating agencies. While that more interested in the wholesale financing of microfinance institutions. treatment is in line with Basel I and even Basel II, under the discretion provided to the central banks to allow banks the use of a zero risk weight Trends in the banks’ performance and financial soundness. for domestic government debt in domestic currency even if not supported by Inevitably, the timing of the work on this paper meant that the economic current ratings, it remains problematic. There are two reasons for this: first, and financial impact of the Egyptian revolution was only emerging as the it does not recognize the actual risk situation; and second, it distorts the work was undertaken. With regards to the banks, in particular, interviews incentives for banks with limited capital to lend to government rather than in the field suggested a significant decline in activity, rise in NPLs and the more productive private sector. necessary provisions, and a sharp overall decline in profits for 2011 by more than 20 percent. Despite the recent broad downgrade of Egyptian banks by There was an improvement in the banks’ assets quality, as evidenced international rating agencies (citing poor asset quality, low capitalization, by the decline in NPLs in percent of total loans to 13.4 percent by 2009, and doubts about the government’s ability to support banks), most bankers about half its level in the early 2000s. However, compared to the average for voiced optimism about a recovery in 2012 and longer term prospects. The the MENA region, as well as all other comparator regions (with the recent review below should be viewed in this context. There could be significant exception of the countries of the CIS), the NPLs ratio is still high, and further deterioration in many financial performance indicators in 2011. resolution of outstanding NPLs remains a priority to clean up the balance sheet of banks and improve their profitability. Interestingly, the recent The Egyptian banking system has made significant progress in global financial crisis did not reverse the downward trend in the NPLs ratio, strengthening its financial performance and soundness in recent years, better in sharp contrast with the situation in other regions, especially among AEs, positioning it to meet the financing needs for sustained economic growth going emerging Europe, and the CIS. A substantial share of the Egyptian banks’ forward. This has reflected the implementation of the financial sector reforms, income was put aside in recent years to build provisions against NPLs, with and cautious management practices that have built up provisions and capital in overall provisions covering more than 100 percent of NPLs by 2009. addition to expanding the banks’ lines of business. It has boosted confidence in the banking system by both depositors and investors. Admittedly, one consequence Profitability indicators improved as well, with the average ROA and ROE of reforms was that aggregate credit grew more slowly than economic activity for reaching 0.8 percent and 13 percent, respectively, in 2009, almost twice their some time, in sharp contrast to the developments observed elsewhere. However, levels of 2003. Both indicators were affected little by the global financial crisis. this seems to have largely reflected both the clean-up of NPLs, and the elimination Nevertheless, the rate of return on assets has remained well below the levels of non-prudential lending. It should not necessarily be interpreted as evidence generally observed in all comparator regions before the global financial crisis, of a worsening in the access to credit for emerging private businesses, even if though the rate of return on equity has been more at par. The lower return on the level of access clearly remains problematic. The financial, institutional, and assets would in part reflect the high leverage ratio among banks, as noted earlier. operational restructuring of the three remaining public commercial banks, and The relatively weaker performance of the state-owned banks continue its impact on both their balance sheet and income position, contributed to the to weigh heavily on the overall banking profitability indicators in Egypt, also overall improvement. raising questions about the consistency between the business model of state- 168 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 169 owned banks and the objective of diversification and enhancing access to Quarterly financial statements of banks are now substantially credit. Indeed, excluding these banks, the rates of return on assets and equity improved, in terms of both coverage and standardization, and quality of the among private banks (both domestic and foreign), have been around 1.7 and financial information included. These financial statements are required to 20 percent, respectively, high by international standards. Lower interest be certified by two auditors selected from a list of auditors approved by the margins (net interest income/ assets) among state-owned banks appear to CBE. Each bank must be fully audited by two auditors once each year. A be a main explanatory factor. Such lower returns at the state-owned banks gap relevant to incentives for enhancing access to finance is that the CBE would be consistent with them continuing to offer relatively high deposit quarterly reporting requirements do not seem to include either information rates to attract retail depositors and charge relatively low lending rates to on the structure and concentration of the bank’s shareholders, or information traditional corporate borrowers.9 on the loan concentrations in relation to the largest borrowers. This raises Regarding the sensitivity of the banks’ soundness to various risks, questions on the priority attached to such concentrations in the assessment credit risk associated with a potential deterioration in asset quality as a result of risks and overall bank governance. of adverse macroeconomic shocks remains the main vulnerability. A stress With the growing significance of brokerage, financial leasing, and mortgage test performed for the FSAP update (2007) considered the implications of a finance subsidiaries and affiliates, it is becoming increasingly important to downgrade in each debtor category, resulting in additional provisioning, for each require all banks to move to a quarterly reporting of their consolidated operations bank’s CAR. The average CAR was reduced by a minimum of 3 percentage points as well. This would enable solo and consolidated supervision of banking groups and, more concerning, the share of system assets accounted by the banks falling to be performed consistently taking into account the most current developments. below the minimum CAR increased significantly, essentially, because the state- Currently, consolidated financial statements for banking groups need only be owned banks were least able to withstand the shock. A factor that may have reported on an annual or semi-annual basis, although some banks already contributed to enhancing credit risk in more recent years would be the increased disclose consolidated quarterly accounts.12 diversification of the loan portfolio of banks towards consumers and SMEs. At Well designed and enforceable secured transactions rules. The the same time, an associated reduction in loan concentrations towards large Mortgage Finance Law 148 of 2001 provided for the first time transparent enterprises in the business sector may have had the opposite effect. procedures to foreclose on the property of defaulting debtors. It also allowed for the securitization of mortgages and the issuance of mortgage-backed The Broad Regulatory Framework for Increased Access to Finance securities. In line with provisions under the Law 88 of 2003, a real estate Factors of the broad regulatory framework that have traditionally mortgage against a bank loan has to be registered with a local notary public. encouraged Egyptian banks to grant credit to mostly well established and The administrative procedures to register a property right in the form of connected large enterprises are multiple. They include distorted incentives real estate title/deed have been streamlined, and the related costs reduced. associated with the dominance of state-owned institutions in both the non- Registration is of course necessary to make it possible for a bank to place an financial and financial sectors; a related governance structure that is not enforceable lien on the property. market-oriented and discourages the taking of new risks; and significant gaps Notwithstanding the above improvements, financial transactions continue in the financial and informational infrastructure. This Section reviews the to be hampered in practice by weaknesses in the legal and regulatory framework progress made in key areas of the broad regulatory framework most relevant and its enforcement. In the case of many older urban areas, title registration for increased access to finance, and addresses certain remaining gaps.10 remains a lengthy and uncertain process, even if now it is less costly. Only a Reliable financial reporting and auditing. Reliable financial fraction of the housing stock has a registered title, as registration of property is reporting and auditing facilitates access to finance by enhancing the not mandatory in Egypt for a legal real estate transaction, except in the case of confidence of creditors and investors, and the credibility of borrowers. The a mortgage credit application. Reportedly, 45 percent of new urban housing is latest Egyptian Accounting Standards (EAS) were approved by a committee produced by the informal sector, preempting mortgages because CBE regulations headed by the Minister of Investment in 2006, and became effective at the require proof of a building license. With the banks or housing finance companies beginning of 2007. They comply with IFRS in all material respects. In 2005, often unable to extend mortgage finance to home buyers, the latter have had to the CBE published a set of auditing guidelines and rules to support the rely on installments deals with the developer, if available. Furthermore, the lack quality and independence of auditors assigned to audit firms that apply for of a centralized mortgage registry has been identified as a major weakness in the bank credit. Seeking to ensure, inter alia, that IFRS standards fully apply informational infrastructure. to the financial statements of registered banks as well, the CBE approved on Clearly, greater flexibility is needed to facilitate home mortgage December 16, 2008 new rules for the preparation and presentation of banks’ financing, while recognizing the imperative of maintaining prudential lending financial statements conforming to these standards.11 practices and financial soundness. Already, an executive regulation allowing 170 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 171 mortgage finance for a “register-able” property has been issued, and banks that the majority of Board members must be Non-Executive Independent do extend housing loans based on a “power of attorney”. It is also proposed to Directors. The CBE has also made it clear that it prefers that the Chairman set up a simplified “interim” real estate registry, especially for register-able of the Board is a Non-Executive Director, and requires an explanation if it properties, which could form the basis for a special form of mortgage collateral is not the case.15 Furthermore, each bank must have an Audit Committee that could likewise be registered in an interim mortgage registry.13 Another composed of three Non-Executive Directors, in addition to an Executive supportive measure would be encouraging the development of market- Committee. Moreover, the management of the bank has to submit to its Board based title or “quasi-title” insurance, the latter specifically for register-able of Directors, at least semi-annually, an evaluation of investment and loan properties. There could also be a review of the CBE regulations generally portfolio risks, and measures to address them. However, there is currently no prohibiting bank mortgage finance for residential units under construction requirement to have a Risk Management Committee separate from the Audit and for informal housing, assuming strict conditions and guarantees under Committee. A separate Risk Management Committee would allow it to focus which such lending could be possible. exclusively on a forward-looking assessment of the risks faced by the bank. It A significant gap with secured transactions appears to be the lack of could also be legally assigned the responsibility to vouch for the adequacy of a legal regulatory framework for the use and registration of a broad range the bank’s risk management policy. of movable property as collateral. This is of particular significance in the The listing on the EGX of commercial banks operating in the country case of lending to consumers and SMEs (see below). This issue was identified offers further support for improving corporate governance and transparency. by several interlocutors as a major impediment to access to finance. The In addition to quarterly financial statements, listed banks must disclose introduction of such a framework for movable collateral, as well as the additional information on their governance and ownership structure that establishment of a centralized registry for movable collateral is a priority. generally go beyond the CBE disclosure requirements for other banks. The regulations should clearly state the right of creditors to dispose of Additionally, listed banks are required to publish the quarterly Auditors the collateral upon default without the need for court intervention.14 The Committee reports. The committee is established as per the Egyptian Code centralized registry should also be designed to clearly establish the priority of Corporate Governance and the Listing and Delisting rules at EGX. This is of secured creditors. further contributing to confidence as well as market discipline and efficiency. Finally, the outdated bankruptcy law needs to be revised because it Disappointingly, among the 39 banks registered in Egypt, only 12 are listed focuses exclusively on liquidation. This un-necessarily increases the expected on the EGX, and only 9 have a credit rating from an international agency.16 and actual costs of insolvency for all concerned. Reportedly, the court While the prospect of an IPO is likely to remain the main incentive for banks procedures for liquidation also continue to be slow and cumbersome, further to seek a stock market listing, greater conformity between the CBE and EGX making creditors extremely reluctant to lend. A new bankruptcy law should governance and disclosure requirements, through further strengthening allow, in addition to liquidation, company re-organizations along Chapter of CBE requirements, could have the effect of tilting the banks’ decision to 11 lines. This would provide for efficient debt workouts and restructuring list (based on a consideration of costs and benefits) in that direction. To the that should include an option to convert debt into equity. The law would also extent that credit ratings of banks by approved credit rating agencies inform establish specialized courts to deal with bankruptcy cases. market discipline, banking supervision should review the use of such ratings in its supervisory framework, based on the Basel II guidelines. The objective Progress with good corporate governance and financial disclosure. would be to ensure that prudential regulations offer the proper incentives Good corporate governance and financial disclosure enhances market for banks to seek such ratings, recognizing at the same time the need for discipline and efficiency, and promotes an incentive structure that encourages transparency and reliability. more diversified lending. All banks are subject to the corporate governance and disclosure requirements of the Egyptian Company Law, and of the While the State’s divestiture from joint venture banks and one state-owned EGX’s listing, delisting and disclosure rules, if the bank is listed. Bank- bank, and the operational and financial restructuring of the remaining state- specific corporate governance requirements have been highlighted in the Law owned banks have contributed to better corporate governance, the still relatively 88 of 2003. Inter alia, the Governor of the CBE has to be consulted for the large scale of state-ownership of banks implies inherent limitations to the role appointment of a bank’s Board of Directors and its Chairman, as well as its of market forces. Especially if the blanket (but unfunded) guarantee on deposits Executive Directors in charge of credit, investment, portfolio management, were to be viewed as stronger in the case of state-owned banks than private external transactions, and risk management and internal controls. Fit and banks. On the positive side, there is evidence that some of the still state-owned proper criteria for the Chairman of the bank, Board members and Executive banks are now run more competitively, developing new markets and products, and Directors were introduced in 2004 and further strengthened in 2009, and are actively competing with the private domestic and foreign banks. Nevertheless, being assessed on paper and through interviews. There is now a requirement impediments remain. In particular, the ownership function at the restructured 172 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 173 state-owned banks remains fragmented, as the general assembly does not 83,000 SMEs, or about 95 percent of borrowers, except in the case of microfinance appoint/dismiss the Board of Directors (appointed by the Prime Minister), and borrowers, where the coverage is significantly less. Only one network of microfinance the Boards would in practice still be dominated by Management. NGOs is currently member of I-Score. National ID numbers are helping in setting Despite the progress made in recent years, there is still significant room up customer files. An I-Score report is now obligatory for any loans by banks (only) for improvements in the amount, quality, and frequency of public disclosure of before extending the credit. Clearly, this requirement should be extended to the information by individual banks. In practice, beyond the balance sheet, income other financial intermediaries as well. The information collected by I-Score appears statement, cash-flow statement, and change in equity and profit appropriation to be significantly broader than that of the CCR, providing additional inputs to information, the banks’ financial statements often offer only limited information the assessment of any potential borrower’s credit worthiness (such as historical on corporate governance, and risk management and internal controls. There are inquiries, payment history, un-honored checks and legal pursuits). Scoring models in fact very large variations among individual banks in the quality of financial are extensively used. There is evidence that the work of I-Score has contributed statements in this regard; and the same is true in the case of Annual Reports.17 to both an improvement in payment discipline among borrowers covered, and the Another difficulty is that the many banks that are either branches of foreign banks number of individuals and SMEs with access to credit. or unlisted subsidiaries of foreign banks do not publish separate Annual Reports at Going forward, a priority would be to ensure that the fees of the credit all, even though their foreign groups do, on an individual and consolidated basis, bureau do not discourage microfinance institutions, in particular, from but without identifying separately the accounts of their Egyptian subsidiary. becoming members of I-Score and using its credit information. It should be Availability of reliable credit information. Egypt has made significant possible to negotiate fee structures/ packages that would allow almost all progress with regard to the availability of reliable credit information, a key micro-finance institutions and loans to be brought under I-Score. Given the requirement for facilitating greater access to finance, but more can be done. Such positive externalities involved, some form of fee subsidy from government information is of course key to a lender’s decision to grant a loan. The CBE’s could be considered. Consideration should also be given to invite major utility Central Credit Registry (CCR) envisaged in the Law 88 of 2003 was made fully companies, including mobile phone companies, to participate. operational with the CBE Board of Directors’ regulations of April 26, 2005. It covers The Management of I-Score has identified two potential areas for all loans above LE 30,000 extended by banks, mortgage finance and financial extension of its activities, which could also help with increasing access leasing companies, and also the Social Fund for Development. The lenders to finance. The first would be the creation of a central registry for both can access the CCR on line, and the database now includes both negative and immovable and movable collateral (assuming for the latter that an appropriate positive information, as well as information on any rescheduling agreement. The legal framework is put in place), also consolidating all current sources of regulations specify: the list of documents and declarations that banks, financial information on collateral. The second would be the creation of a SME rating leasing companies, and mortgage finance companies must obtain from clients agency, possibly modeled along the line of similar agencies created elsewhere, applying for credit, and the review process they must conduct before granting the e.g. India’s SMERA (Box 5.1). Again, modest government subsidies in these credit; the reporting requirements to the CBE for new clients and the updating areas could offer a fairly large bang-for- the buck. of the CCR to reflect the existing clients’ latest position, on a monthly basis; and notifying the CBE on bank clients who are not regularly meeting their payment obligations, with special provisions as regards consumer loans. Box 5.1: Example of SME Rating Agency: India’s SMERA With a view, inter alia, to broadening the scope for bankable projects, SMERA was the first comprehensive and independent credit rating agency Amendments to the Law 88 of 2003 foresaw the establishment of private credit specifically targeted at micro and small and medium size enterprises (MSMEs) bureaus.18 The establishment of a private credit bureau offering a reliable and established in India through a joint venture between leading business information comprehensive database was a significant objective under the Financial Sector services and banks. It offers two different scales for rating of a MSME: the first Reform Program supported by the World Bank. The private credit bureau “I-Score” focuses on a size indicator based on net worth, and for each (of the four) net established in 2005 as a regulated monopoly, majority-owned by the banking sector, worth classification, two possible values for a composite appraisal indicator; became fully operational in March 2008. Membership is open to banks, mortgage the second focuses on a broader financial strength indicator, and for each (of finance and financial leasing companies, retailers (major department stores), as the three) financial strength classification, two possible values for performance capability. The rating fee structure is based on the enterprise turnover, and in well as microfinance companies, and brokerage firms (for margin trading). The fee the case of eligible MSMEs, can be partially reimbursed through the National structure differentiates banks from non-bank members.19 For individuals, there is Small Industries Corporation (a state-owned enterprise fully owned by the Indian no low or upper limit for the size of loans covered; for SMEs, the size of loans covered government). Up to 75 percent of the rating fee can be reimbursed, to a maximum range from LE 1 to LE 1 million (beyond, the CCR is the sole depository of the credit of Rs 40,000 depending on the size of the enterprise’s turnover. information). Currently, the I-Score data cover about 7.5 million individuals, and 174 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 175 Entry and exit rules that promote competition. Greater competition As to exit rules, the Law provides for clear circumstances under which should incentivize the banks to broaden their lending activities. Many the Board of Directors of the CBE can withdraw a bank’s registration, and restrictions that existed on new domestic and foreign banks trying to enter the specifies the various actions the Board can take with regard to any bank in Egyptian banking market have been formally lifted, but significant hurdles financial difficulties, but a full-fledged banking resolution regime remains remain. The Law now makes clearer the procedures for consideration of an absent. In particular, the ability of the CBE supervisor to impose a moratorium application and granting of registration (license). Nevertheless, the Law still on the bank’s obligations and to restructure its liabilities is unclear. In seems to leave much discretion to the CBE for rejecting applications, and practice, banks have not been allowed to fail. The standard approach seems to lack disclosure requirements on the proceedings. The possibility under to have been merger encouragement, or bailout, with government or CBE the Law for a foreign bank to start a green-field banking subsidiary in support. While a source of stability for the banking system, this approach Egypt should also be clarified. The minimum capital requirement to obtain may have undermined the competitive advantage of healthier banks. a banking license set in 2003 still looks high by international standards, Going forward, ending the moratorium on new banks and further but less so now that many countries have raised theirs in recent years.20 In commercialization and privatization of state-owned banks are priorities, as is the reality, most banks in operation today in Egypt obtained their license well introduction of a full-fledged banking resolution regime. In parallel to this, the before 1985. Since then, it appears that only one new bank registration was introduction of a uniform, limited, and funded deposit insurance scheme should be granted, in 2006. The CBE has applied a de facto moratorium on new licenses considered, when macro-financial stability allows it. These reforms would contribute on the ground that Egypt has been “over-banked”. to create a level playing field and encourage growth and competition. The end of the While the de facto moratorium on new bank licenses would suggest a moratorium, in particular, could open up the prospect of new “niche” banks (e.g. lack of competition associated with a static banking landscape, there have SME traders, manufacturers) filling up current gaps in the access to finance. been, in fact, dramatic structural changes in this landscape. These have been Addressing via banking supervision the problem of loan concentration associated with significant ownership changes brought about by divestiture, in banks, through limits on large exposures and connected lending, should mergers, and acquisitions in the context of the government’s financial sector also force the banks to become more competitive in expanding their business reform program. The foreign presence in the Egyptian banking system, (see further below). including through subsidiaries in addition to branches, offers the prospect of a spill-over of know-how, good governance, new products and technology, and Banking Supervision for Enhanced Access to Finance generally greater competition. A recent comprehensive study of the impact of This Section of the paper turns to banking supervision, the nature and financial sector reforms on the competitiveness and efficiency of the Egyptian direction of which can constrain or expand the scope for diversification in banking system concluded that while the sector remains one of monopolistic bank financing towards sectors currently under-financed sectors. competition, both competition and efficiency has increased since 2002.21 Enhanced access to finance necessitates that banks be able and willing Having said this, banking concentration remains relatively high, with the to move up the ladder in terms of individual risk taking, and banking three largest banks still accounting for about 40 percent of banking assets supervision must be supportive of this process. The proper pricing of risk in 2009, but down from 50 percent in 2006. Interestingly, one private bank then becomes central to the banks’ financial performance, soundness, and (the CIB) now occupies third place in terms of assets among the largest three stability. At the same time, greater diversification of the banks’ activities can banks, while back in 2006, the three largest banks were all state-owned. also, on the aggregate, reduce risks associated with excessive concentration The conditions for approval of new branches should give greater in their loans and investments portfolio. weight to the prospects for increasing access to finance in the location being Clearly, risk-based supervision must accompany this development of the considered. The current conditions were clarified in new regulations approved financial intermediation system. To this end, the Banking Supervision Department by the CBE Board of Directors on June 3, 2008. They emphasize (1) the need of the CBE has been revamped, in line with best international standards. A detailed to focus on under-served areas, (2) the requirement that each bank is covered program for capacity building in banking regulation and supervision during 2006– by LE 20 million of the bank’s capital, (3) the requirement that the bank 2007 was an important element of the World Bank supported financial sector currently abides by all prudential regulations, and (4) the submission of a full reform program.22 The CBE supervises banks through a combination of prudential business plan for the branch, approved by the bank’s Board. These procedures regulations, on-site inspections, and off-site monitoring. The supervision has focused were further streamlined in 2010, with a focus on financial soundness, risk on capital adequacy, asset quality, and liquidity, as well as on an assessment of the management, and efficiency of the bank applicant. The density of SMEs in banks’ own ability to identify and manage risks, and the strength of their internal the locations being considered could be made a pivotal variable in the decision controls. Market and operational risks management are being given greater of which new branches to approve. attention in the context of the move towards Basel II. 176 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 177 Here, we first offer a forward-looking review of the state of play with formalized (in MOUs) interaction between the CBE supervisor and its foreign implementation of risk based banking supervision, and then focus on the counterparts.Off-site monitoring of the banks is fully operational and based interplay between prudential regulations and key concerns relating to on a wide range of information collected from the banks’ weekly, monthly, access to finance, namely (1) encouraging diversification in bank lending; (2) quarterly, and semi-annually, depending on the type of information. supporting housing finance; and (3) facilitating SME financing. Stress-testing of banks has been introduced two years ago, and the Off-site Implementation of risk-based banking supervision. The legal and Monitoring Division contributes to the “bottom-up” approach, with each bank regulatory basis for a reformed banking system was reset in Egypt with the being individually tested. Results are also sent to the Macro-prudential Unit and Law 88, The Law of the Central Bank, the Banking Sector, and Money, 2003,23 consolidated according to various objectives and criteria. It is interesting to note which also defines broad parameters for risk-based banking supervision. in this context that the Head of the Off-site Monitoring Division is currently also Implementation of the Law 88 and subsequent regulations, in conjunction the acting Head of the Macro-Prudential Unit, suggesting close coordination, but with the revamping of the Banking Supervision Department means that also raising questions on the separate status of this Unit. Egypt is now compliant or largely compliant with all the Basel Core Principles Stress testing is conducted annually (and on special events) on for Effective Banking Supervision and Transparency of Banking Supervision. Egyptian Banking Sector to determine the combined impact of borrowers’ The CBE supervises banks through a combination of prudential regulations, credit rating’s downgrade, EGP currency devaluation , and investments on-site inspection, and off-site monitoring. portfolio devaluation on banks’ profitability, capital adequacy & liquidity. Prudential regulations. They appear generally in line with best The following were the underlying assumptions for stress testing international practices. Various limits on exposures apply, including for single conducted: customer and related parties, the bank’s related parties, investments, real 1. Haircut of Net income by 20% estate lending, and exposure to single foreign correspondent. Regulations on exposure limits to single consumer and related parties and the bank’s related 2. Credit Test Assumptions: parties which, although largely motivated by prudential concerns, play a role ϘϘ Banks’ collateral was reduced by 50%, excluding cash collaterals in encouraging loans diversification and therefore access to finance. These and banks’ guarantee. exposures have been a significant concern in the case of Egypt, and there has ϘϘ All corporate credit facilities and exposures of retail and SMEs clearly been much progress in addressing them, though there appears to be were downgraded according to 4 scenarios: room for some further strengthening. ■■ First Scenario: 50% of corporate credit facilities in each notch and On-site inspection, off-site surveillance, loans classification, 10% of that in retail and SMEs were downgraded by one notch, and provisioning. The on-site inspection process is now fully aligned ■■ Second Scenario: 100% of corporate credit facilities in each with a risk-based approach focusing on credit policy, the risk management notch and 20% of that in retail and SMEs were downgraded system and internal controls, and the IT system. The on-site inspection by one notch, focuses on the credit risk, compliance with prudential regulations, quality of ■■ Third Scenario: 50% of corporate credit facilities in each notch corporate governance, risk management and internal controls, and financial performance and soundness of the bank. Market and operational risks are were downgraded by two notches, and 30% of that in retail also assessed, though they currently have no direct bearing on the derivation and SMEs were downgraded by one notch, of the CAR, even after the full implementation of Basel II due to its small size ■■ Fourth Scenario: 100% of corporate credit facilities in each compared to credit risk. notch were downgraded by two notches, and 30% of that in There are doubts about the ability of on-site inspections to perform retail and SMEs were downgraded by one notch examination of banking groups on both a solo and consolidated basis. The ϘϘ Resulting shortage in provision after conducting the stress test is process seems to be hampered by the lack of timely consolidated accounts, added to existing shortage or surplus (if any) in provision. due to the different frequency of reporting. Furthermore, given the growing 3. FX Devaluation Assumptions: number of non-bank financial subsidiaries and affiliates of banks, the need ϘϘ Assuming further devaluation of Egyptian pound against foreign to strengthen and formalize (with MOUs) the exchange of information currencies, and determine the impact on CAR between the CBE and EFSA is becoming more imperative. Recently, the CBE and EFSA supervisors have established a “coordination committee” which 4. Investments portfolio Devaluation Assumptions: meets weekly. The increased significance of foreign banks as groups holding ϘϘ Assuming different scenarios for devaluation of debt & equity banking subsidiaries in Egypt also enhances the need for strengthened and investments and determine the impact on CAR. 178 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 179 The current focus is understandable given the current structure of the capital base as well, though goodwill and losses are. Assets and contingent banks’ balance sheets, but will have to be broadened as exposures evolves, liabilities are calculated on risk-weights ranging from 0 to 100 percent, and and also Basel II comes into effect. Stress testing for the interest rate risk above 100 percent for some classifications. The latter applies to the financing (for both the cash flow and valuation effects of changes in interest rates) and of real estate development companies (when the leverage exceeds 2:1), with the liquidity risk is likely to gain greater prominence. a risk-weight potentially up to 232 percent,28 as well as for the financing for The system for assessing credit worthiness (“Obligator Risk”) and mergers and acquisitions, which carries a risk-weight of 150 percent in case governing the loans classification and provisioning by banks in Egypt was the acquiring company is an anchor investor and 200 percent when it is not revamped by the CBE in new regulations approved on May 24, 2005, in line (e.g. investment fund).29 with international standards. The general treatment of “watch loans” (i.e. So far, the banks have not been obligated to charge capital against loans regularly in arrears, but for less than 90 days)24 and of their provisioning either market or operational risk, for calculating capital adequacy. for the purpose of calculating capital adequacy is too lax. These loans attract Reportedly, these risks are already assessed during the on-site inspections in a minimum 5 percent provisioning requirement which is, however, treated as determining capital adequacy. The move to a risk-based banking supervision a general provisioning. The apparent inclusion of these provisions in eligible is being further strengthened in the context of the phased implementation of capital would over-estimate the capital strength of the bank. It should be the Basel II framework. Egypt banking supervision intends to implement the noted, however, that stricter criteria for loan classification and provisioning standardized approach, even if some banks already use an internal ratings- apply for consumer lending. based approach. The implications of Basel II for capital adequacy mainly The main objective of the Macro-Prudential Unit is to regularly assess result from (1) a few modifications in the definition of eligible regulatory the financial soundness of the Egyptian banking system on the aggregate capital, (2) considerable refinements in the ways assets are risk-weighted level, and the systemic risks it may face, taking into account broader economic for the purpose of calculating capital adequacy, and (3) the incorporation of and financial developments in the economy. In this context, a number of capital charges for the market and operational risks.30 One modification to aggregate micro-prudential indicators relating mostly to banks are being eligible capital, which could constrain some Egyptian banks, relates to the monitored and published, as well as a list of standard macro-economic and deduction to be made for significant investments in commercial entities.31 market indicators that could shed light on the sources and nature of possible Among the additional credit risk sensitivities, the requirement that past shocks.25 Greater attention needs to be paid to the composition and maturity due loans and other higher-risk categories should carry risk-weights of up to of capital flows, interest and exchange rate levels, adequacy, and volatility, 150 percent could also affect some banks. The requirement to charge capital possible sources of contagion effects, credit ratings, indicators of excess yields, for the market risk and, especially, operational risk could also be more and sovereign yield spreads. Outside banks, developments in other sectors of problematic for some state-owned banks, reportedly. the economy also need to be closely monitored, including key financial data The above adjustments and recognitions will certainly affect the CAR on nonbank financial institutions, nonfinancial corporations, households (in negatively, but perhaps not dramatically. In conversations, the Banking particular, debt levels and debt servicing burden), and real estate markets Supervision Department expressed confidence that Basel II standards would (in particular, price trends, and trends in real estate lending), as well as not expose significant capital shortages for banks in Egypt, based on the current indices of financial markets’ liquidity. minimum 10 percent CAR. However, and especially for the banks closer to this Capital adequacy. The CAR (risk-weighted assets and contingent minimum CAR, banking supervision will need to assess whether the banks’ liabilities to capital) is a key indicator of a bank’s ability to absorb potential remaining capital buffer is sufficient in view of their specific risk profile. losses. It is also an indicator of the scope for further expanding risk taking Basel III will have further implications for capital adequacy, and activities, the need to contract such activities, or to add capital. It thus affects beyond, for access to credit.32 The global financial crisis of 2008–2009 exposed the growth of financial services and access to finance. fundamental weaknesses in the business model and risk taking strategy Until now, the CBE has generally applied the Basel Capital Accord26 of banks, especially those in the AEs which had been at the forefront of for the calculation of the CAR. It raised the minimum requirement from 8 sophisticated forms of products (both on the asset and liability sides) to expand percent to 10 percent in 2003. Tier I capital and Tier II capital have been their on and off-balance sheet activities, and their incomes. The international recognized.27 The framework is to apply both on a solo and consolidated basis regulatory and supervisory response to the crisis has been far-reaching, and for the banking groups (see, however, earlier concerns on the effective and by late 2010, broad agreement on significant changes in the regulatory and timely implementation of this). The branches of foreign banks are not subject supervisory framework had been reached, forming the so-called Basel III to the CAR requirement. Investments in banks and financial institutions, framework. The limited direct exposure of the Egyptian banking system to other than subsidiaries under consolidation, are apparently not netted from developments in international banks and financial markets abroad shielded 180 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 181 it, for the most part, from the direct and worst consequences of the crisis. years, as the number of clients with loans per 1,000 adults rose sharply from Nevertheless, Egypt will be affected by the new regulations. First, because barely 30 in 2006 to about 80 by 2009. Nevertheless, the importance assigned the large international banks that operate branches in the country or are sole to large exposures to single clients during the on-site inspection and off-site or majority owners of domestic banks will operate under the new framework. monitoring is still not entirely clear. As already mentioned, the requirement Second, because Egypt would be expected to implement the new framework that such exposures be disclosed in quarterly financial statements would appear domestically as well. This would strengthen banking soundness at a time when to be absent. In practice, they are not disclosed, while concentrations among an expansion of the financial sector is poised to sustained economic growth. customer sectors, geographical areas, business activities, and transactions with Sound liquidity management. The ability of a bank to meet cash related parties, evidently are. There is a need to establish a stronger linkage demands in more difficult circumstances is part of its financial soundness; between management of these exposures and progress with diversification and and in this regard, the CBE has introduced strong liquidity management access to finance, in addition to the assessment of risks and capital adequacy. requirements. The policy was detailed in a February 22nd, 2005 CBE In particular, approval of new branches could, in part, be conditioned on the Board Decision obligating the banks to (1) develop or update their liquidity bank’s performance regarding large exposures. management policy, to be approved by each bank’s Board and submitted The system of loan classification, collateral, and provisioning must to the CBE; (2) submit a memorandum reporting on their current liquidity be reviewed from a perspective of access to finance because it affects the management capabilities and experience; and (3) develop their IT and human portfolio decisions of banks, and thus who receives credit. “General” rules resources to implement their strengthened liquidity management policy. This based on traditional banking that focus on established corporations run policy needed to cover: (1) an analysis of the relative importance of various the risk of ignoring characteristics related to lending to more diversified sources of bank funding; (2) a statement of maturities of assets and liabilities,33 sectors. As a result, specific risks and access issues may not be adequately for the purpose of identifying the maturity mismatches, setting maximum limits addressed. The regulatory challenge is to have rules that are flexible enough as a percentage of the bank’s liabilities, and monitoring them; (3) a strategy to to accommodate the characteristics of particular borrowers, with a view to manage liquidity on a daily basis, based on a projected cash-flow identifying facilitating their access to finance, without sacrificing any of the legitimate surpluses or deficits; and (4) a financing plan to address emergencies under a risk-focused strength of prudential regulations. stress test scenario, to be approved by the concerned Board committee. The Conservative rules currently apply for the type and value of collateral plan, to be reviewed at least once a year, would focus on setting a minimum that can be deducted for purposes of calculating required provisioning. amount of liquid assets to be maintained by the bank to face such emergencies, Generally, only cash, a third party bank guarantee, liquid market securities, and on the ability of the bank to obtain additional resources from the local and real estate are recognized. A Maximum 65 percent of the market value market (contingent borrowing arrangements with other banks, scope for of liquid securities and 50 percent of the fair value of real estate collateral is securitization of part of the loan portfolio). Moreover, it would serve as a basis deductible.34 No allowance is made for collateral in the classification of loans. for setting maximum gap limits for each maturity bucket. Greater flexibility in the collateral regime is needed to facilitate access to All these elements are consistent with the Basle Sound Practices for finance. This would apply to SMEs, in particular (see below). Managing Liquidity in Banking Organization (Basel, 2000), though the need Special credit risk classification and management as well as to have an adequate system of internal controls over the bank’s liquidity risk provisioning rules tailored for consumer loans, residential real estate management process should also be stressed, including through independent loans,35 and small enterprise loans have already been introduced. Some of reviews and evaluations. It has not been possible to assess in any detail how these rules tend to be more demanding than in the case of business loans.36 the current practices among Egyptian banks also conform to the revised In particular, the loans are subject to a 3 percent general provisioning international liquidity risk management standards introduced under Basel requirement, and credits that are in arrears for 30–90 days are already III, but the overall impression is that of great variance in standards among treated as sub-standard and subject to 10–20 percent provisioning. the banks, based on the disclosed information. Others, however, appear fairly lax. For real estate loans in particular, the Encouraging diversification in bank lending. While mostly aimed provisioning is based solely on the amount of unpaid installments. There at containing credit risk concentrations, limits to bank exposure to a single is no early recognition that the entire loan might be bad. Furthermore, 100 client and its related parties, and to parties related to the bank itself also serve percent of the Fair Market Value of real estate collateral can be recognized to encourage diversification and competition. The introduction of these limits for residential real estate loans, which appears to be an exception to the 50 in Egypt in 2006 addressed a long standing problem, although by international percent rule applicable for all other types of loans. Except for the general 3 standards, there continues to be room for further tightening of these limits. percent provisioning requirement, other regulations for small loans related There is in fact evidence of a reduction in the concentration of loans in recent to economic activity are basically the same as for regular corporate loans. 182 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 183 The regulations applicable to retail lending do not seem to have hindered Banks are competing with the mortgage finance companies for their its rapid growth since 2005, with its share of total bank credit doubling to share of the mortgage finance market, and there should be a level regulatory approximately 15 percent. However, this development has mostly reflected playing field to ensure that competition is fair. In fact, there are currently the surge in consumer loans (especially credit cards, personal loans, and car significant regulatory differences. For instance, provisioning requirements loans). Despite the accommodating regulatory environment, there was only are laxer in the case of mortgage finance companies (1 percent general limited growth in residential real estate loans and small loans related to provisioning requirement rather than 3 percent for banks; 5 percent economic activity in the period. provisioning requirement for a one monthly installment delay rather than 20 Mortgage finance. Access to home-ownership in Egypt for all social percent for banks). Mortgage finance companies are also allowed to finance classes except the wealthiest is hampered by the limited development of housing under construction, while banks are prohibited from doing so. On a mortgage market in the country. Reportedly, total housing mortgages the other hand, mortgage finance companies are obligated to pay ½ percent outstanding at end 2010 were less than EP 5 billion (75,000 customers), still of their mortgage interest charge into a subsidy fund to support access to representing less than 1 percent of GDP (compared to 14 percent of GDP mortgage finance by low-income families, while the banks are not. Different in Morocco, for instance).37 In the period, the number of mortgage finance loans to value ratios and capital requirements may apply as well. companies rose from 2 to 13. Some 19 banks are now doing mortgage finance. It appears that an increasing number of banks are acquiring mortgage Banks have been very cautious in expanding in this field, often providing finance companies, or setting up mortgage finance subsidiaries, rather than limited financing to homebuyers under their general retail credit facilities, doing mortgage finance using their own balance sheet. This development or to builders with collateral other than mortgage pledges. could reflect the comparative advantages of mortgage finance companies in The lack of, or difficulties with, real estate title registration and assessing credit, but could also result from of the potential for regulatory associated costs and uncertainties have been a major concern for banks and arbitrage. It raises two concerns: first, regulatory distortions would reduce an impediment to lending (see earlier discussion). This, and issues related the efficiency of financial intermediation, with a consequent adverse effect on to the potential maturity mismatch between short-term deposits and long- growth; And second, transferring mortgage finance to a separate subsidiary term mortgage loans, have limited banks’ ability to extend housing financing. is likely to complicate banking supervision even if the subsidiary is fully Variable interest rates are the norm, transferring some of the interest rate risk consolidated within the banking group, not least because the consolidated to the borrowers. The rates are generally benchmarked on the developments reporting requirements are currently less frequent, as highlighted earlier, and of the middle of the CBE “corridor” for the interbank market interest rate, the need for closer cooperation with EFSA. The authorities should undertake with the mortgage finance rate generally reset once a year. Maturities would a full comparative analysis of the differentiated regulatory and supervisory be at most for 10–15 years. environments for mortgages between mortgage finance companies and banks. The objective would be to harmonize the rules where different rules The general rules for mortgage loan limits and eligibility (loan to value cannot be economically justified. (Similar issues may be relevant in the case and installment to income) set by the Mortgage Law 148 are not particularly of leasing finance companies). restrictive.38 It is proposed to further relax the more demanding installment / income ratio limit of 25 percent for the low-income groups, by raising it to 30– Foremost, finding some flexible solution to the title registration 35 percent, a proposal that seems reasonable, especially in view of pressing problem that does not undermine prudential principles is a main pre- concerns to improve access to mortgage finance for these groups.39 EFSA has requisite for enhancing access to and growth of mortgage finance. It would proposed changes to current laws and executive regulation allowing it the open the door to the issuance of mortgage-backed securities and/ or covered authority to set such limits, as opposed to having them hard coded in the bonds, as well as the development of a mortgage securitization market.40 The law. The law provides a number of incentives for banks to increase their earlier-discussed standardized mortgage procedures under a “register-able” role in real-estate financing: some exemptions to the loan/ value limit; right property regime; interim title and mortgage registration; title or “quasi-title” to purchase the mortgaged real estate in case of a short sale; facilitation of insurance facilities; and review of the rules banning bank housing loans in the enforcement actions in cases of default, etc…. At the same time, the banks case of informal and under construction properties, are all policy measures are expected to balance the maturities of their assets and liabilities related to that could prudentially address the access problem, pending a long-term the financing of real estate, abide by the general sound credit extension rules, resolution of the full title registration framework.The greater availability submit a quarterly report on their balance of loans for real estate financing, of mortgage credit guarantees or insurance could also incentivize the banks and in any case restrict housing financing to 5 percent of their total loan to offer more mortgage finance. The limited development and use of market- portfolio. While tight by international standards, this limit is far from being based credit guarantee or insurance facilities by banks in general applies to a constraint so far. housing finance as well. 184 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 185 A significant development in the past few years has been the significant portion of the lending by the state-owned banks has been funded by the incorporation of the EMRC, with local financial institutions, the IFC, the Social Fund for Development, also benefitting from resources of foreign donors. CBE, the Mortgage Finance Fund (formerly the Guarantee and Subsidy Fund The banks have established special divisions and risk management techniques for Mortgages), and the CBE as shareholders. Its main business consists of for the sector. The IFC has also recently signed an agreement with the Bank of refinancing or purchasing of long-term mortgages issued by banks and mortgage Alexandria for the dissemination of its SME Toolkit in the local market. finance companies, using its capital and term resources that it raises on the The development of SME credit has been hampered by the lack of capital markets. The availability of EMRC refinancing should encourage banks comprehensive banking regulations specifically tailored to such financing.45 to extend long-term mortgages at competitive rates, and support the further There has been a growing recognition that a targeted and holistic approach to the development of the mortgage market in Egypt. So far, however, the demand from development of SME financing is called for, for instance to address the difficulty for banks and mortgage finance companies has been easily met without the EMRC the SMEs to offer traditional forms of collateral (real estate assets). having to raise additional funds. Recently, high interest rates have contributed First, several factors must be looked at to assess whether the regulatory to a substantial decline in mortgage activities. and supervisory environment is supportive of SMEs. First, the broader regulatory The issuance of bonds backed by mortgages or other assets would be infrastructure must be conducive to the financing of SMEs as well, with: a good substitute for mortgage securitization as a means of expanding long- ϘϘ Minimum accounting and reporting standards manageable for SMEs. term funding sources for housing finance.41 Such instruments may prove more ϘϘ Credit bureaus or divisions of credit bureaus, specializing in SME transparent and financially sounder than securitization, and more flexible in getting around the difficulties related to title registration. The current strict assessment, using specialized tools such as credit scoring models for rules for the public offering of bonds (150 subscribers minimum) could be small enterprises. reviewed, to see whether greater flexibility is possible.42 ϘϘ Efficiency in the legal enforcement of creditor and borrower rights in Bank lending to the SMEs. The SME sector has played a critical role the case of transactions with SMEs. in supporting productive economic activity in Egypt, as it has elsewhere. It ϘϘ Specialized SME credit rating agencies (see earlier discussion). is destined to be a significant contributor to accelerating economic growth in ϘϘ Raising the efficiency of financial intermediation and reducing the the years ahead. informational and transaction costs. As has been the case elsewhere, SMEs in Egypt have found it difficult Second, the prudential regulations cannot, even unintentionally, be to obtain funding from the formal financial sector. Reasons for this can be biased against the smaller enterprises. This may happen when the design attributed to weakness on both the demand side for credit (lack of proper of regulations is based on inputs more readily available in the case of larger accounting at SMEs, informal rather than formal business relationships, unclear enterprises. In this regard, the general approach is to have prudential business plans and weak management, difficulties in offering guarantees) and regulations that are sufficiently flexible as to take into account special the supply side (banks are ill-equipped to assess the credit risk of SMEs and to features of SMEs, not of course to have weaker ones. Thus, do SME lending in a cost effective way). Sharp asymmetric information between The banks could be allowed to assume an SME exposure based on an borrowers and lenders thus prevails, and results in a less than optimal amount asset conversion cycle or cash flow generation, Trust Receipts,46 hypothecation of financing going to the SME sector.43 Banks do not lend much to SMEs, or of inventories or even machines, and the assignment of receivables in addition charge a high premium. It is estimated that SME lending accounted for less than to more traditional forms of collateral.47 7 percent of total lending in 2009 (extremely low by international standards),44 while their contribution to GDP and overall employment would be more than A new legal framework for movable collateral would serve as 20 and 25 percent respectively, suggesting a failure in the optimal allocation a foundation for the above. The system would need to be supported by a of financial resources. Noteworthy is the fact that “small” enterprises in Egypt centralized registry of movable collateral (as well as immovable collateral). constitute the vast majority of SMEs, numbering almost 40 times the number The consolidation of existing collateral registries that banks must maintain of medium enterprises. There are large business opportunities for the banks under the law could be a good start for this task. to facilitate the passage from small to medium size status for the almost 200 Third, bankers must have a proper incentive structure that thousand small enterprises now operating. encourages them to move into higher reward/ risk lending opportunities, So far, the financing of SMEs appears to have occurred mostly through rather than remain biased towards lending to large and well-connected the three state-owned commercial banks, the CIB, and the Bank of Alexandria. enterprises. This can only be achieved through greater competition among However, other banks are expanding their activities in this sector as well, banks based on market-oriented practices including corporate governance. including subsidiaries and branches of foreign banks such as Barclays Bank. A Further, the commercialization and reduced dominance of state-owned banks 186 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 187 is likely to be a key factor in this regard, which would also be facilitated treatments that in the long run may be adverse to financial stability and efficiency, by further privatization. The current involvement of SOEs with SME as well as costly. Unfortunately, the recent CBE regulations giving a special lending may reflect more the fact that they have been chosen to implement exemption for the cash reserves requirement when deposit resources are used the government’s policies for the sector, and to channel available financing to extend SME loans, while well intentioned and accompanied by other positive resources to it, rather than facilitate market-based diversification. measures, largely falls in this category of palliative (Box 5.2). General subsidy schemes for lending to the SMEs should be avoided, because they are very much second best in terms of their cost and poor targeting. Market-based SME loan Box 5.2: Special Provisions for SME Funding guarantee/insurance scheme should be considered instead of subsidized state- run ones. This would not, however, preclude possible government intervention to With a view to encouraging higher SME lending by banks, the CBE approved facilitate the emergence of relevant institutions. on December 16, 2008 special provisions to govern SME lending.1 A specialized unit at the Egyptian Banking Institute is established to serve the banks in Credit guarantee/ insurance should play a more important role in setting up specialized SME departments; the banks are to coordinate with the mitigating the credit risk assumed by banks when they take exposures, stakeholders policies targeted at providing credit to qualifying SMEs without especially longer term, to more risky borrowers such as the SMEs. In this prejudice to sound prudential rules; and to develop with the stakeholders the regard, with the state-regulated Credit Guarantee Company the only necessary infrastructure for the expansion of SME lending, including credit significant player and covering only a very small amount of loans, there is a bureaus, credit rating companies, credit guarantee and insurance companies, clear gap in the financial infrastructure for SME financing in Egypt. etc. It is also proposed that all the stakeholders coordinate an effort to propose legislative amendments that would facilitate SME lending with measures that The experience elsewhere with private sector-led Financial Guarantor would address and minimize the associated credit risk. Funds, in China in particular, should be studied to see whether they could be replicated in Egypt. Ideally, a Financial Guarantor Fund would leverage the More specifically, the special provisions also exempt the banks from the statutory informational and enforcement advantages it has over a bank to help enable cash reserves requirement (of 14 percent) for the amount of deposits equivalent SMEs to obtain, with the guarantee of the Financial Guarantor Fund, loans to the amount of lending granted to SMEs since January 1, 2009. Qualifying SME lending is for firms with turnover or annual sales up to LE 20 million, which they would not be able to get otherwise (or only at a significantly higher and a paid in capital between LE 250,000 and 5 million. Notwithstanding the cost). Under the Financial Guarantor Fund, the risks are bundled, can be priced monetary policy or prudential reasons for a statutory cash reserves requirement, less than they otherwise would, and transferred from the banks to the Fund. Key it can be viewed as amounting to a tax on financial intermediation for the banks. to the financial soundness of these entities is that they are properly capitalized Hence, the exemption of this requirement targeting the SME lending is akin and that the fees paid by the beneficiaries properly price the risks associated with to a tax expenditure benefiting the bank and/ or the SMEs (of course, it also the bank loans. They must also genuinely be adding –value to the informational has implications for the bank’s liquidity position). The final incidence of this and enforcement activities. This is why local chambers of commerce/ business tax expenditure is unclear, since banks could either simply enjoy a larger profit margin, or pass on the benefit to the SMEs in the form of a lower interest rate. associations could be especially well equipped to be founder of such entity. Provided all these conditions are met, the existence of Financial Guarantor In addition to their own funds, informal sources, and the banks, the SMEs have Funds should improve access and enhance efficient financial intermediation. had access to formal financing through the Social Development Fund (often Specific regulations governing the securitization of SME loan portfolios channeled via the banks), and very recently, the SME stock exchange (NILEX). should be issued, with a view to enhancing the amount of financial resources In this regard, the regulations restate the guidelines the banks must comply with going to the sector. The securitization model offers the prospect of alleviating for the auditors who audit the financial statements of business customers applying the likely bank capital shortage in the case of a significant move in the direction for bank loans. In case of a partnership wanting to access a credit facility of less of SME lending, developing non-bank financial intermediation, and fostering than LE 1 million, the auditor may be from the register of auditors for partnerships greater integration between banking and the capital markets. The regulations rather than corporations. Only in the case of micro-enterprises wanting to borrow will need to insist on the full transfer of the credit risk to the investors, and less than LE 100,000 can the requirement of regular bookkeeping be waved. provide credit rating rules for such securities, in accordance with Basel II. SME bank credit growth targets could also be useful as an indicator of the progress made in supporting this under-financed sector. Nevertheless, they The policy approaches need to address the fundamental information and should not be binding, nor should financial penalties be associated with failure institutional weaknesses that discourage lending to SMEs, rather than being for a bank to meet them. At the same time, performance under these targets merely palliative. They are preferable to approaches that take these weaknesses could be used by the central bank as a criterion for certain related decisions, as given, and try to compensate the banks for their costs, or introduce “special” for instance as regards allowing new banking branches. 188 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 189 Non-Bank Financial Services Regulation a negotiated settlement, provided that it imposes a money penalty of at least twice the minimum amount specified in the law for the violation. EFSA, the Consolidated NBFI Regulator Criminal violations are subject to prison terms of up to five years and/ The Egyptian Financial Supervisory Authority (EFSA) was created or fines of not less than LE 50,000 to a maximum of LE 20 million (§63). The by Law 10 of 2009, which consolidated the Capital Market Authority Capital Market Law specifies lesser sanctions for certain violations (§64–69). (CMA), the Egyptian Insurance Supervisory Authority (EISA) and the Mortgage Finance Authority (MFA) into EFSA. EFSA is headed by a seven Insurance Regulation person Board, composed of the EFSA Chairman and two Deputy Chairmen, Egypt’s insurance Law 10 of 1981, as amended by Law 118 of 2008 and appointed for four-year terms and four additional members appointed by Law 10 of 2009 provides EFSA with broad authority to license companies, the Prime Minister. The Deputy Governor of the CBE serves as the seventh and approve appointments of senior officers and members of the board of member of the Board. The Board is the final authority on all EFSA matters directors. It is responsible for business conduct regulation and has limited and has authority to set the EFSA budget. The EFSA budget includes funds rate-setting authority for MTPL insurance. EFSA oversees company appropriated by the government, fees collected by EFSA at rates set by law, solvency, reserve and capital requirements. It conducts on-site inspections revenue collected for services performed and fines imposed by EFSA for of companies and can impose small fines for infractions. EFSA also has some violations of the law. degree of authority over governance. For example, EFSA approval is required EFSA was created to improve the effectiveness and efficiency of the for foreign ownership of more than 10 percent of a company. regulatory system for NBFIs by consolidating three separate agencies into Insurers are required to have minimum capital of LE 60 million. Only one. Under the EFSA strategic plan, the discrete regulatory programs of each half of this amount is required initially, with the remainder in five years. The of the three agencies were to be consolidated by 2011. For example, there 2009 amendments to the insurance law prohibited a company from operating would be a single inspection program for all regulated entities, a combined as both a life and property insurer. A separate license is required for life enforcement program, a combined legal department, and a consolidated insurers, with an additional initial capital requirement of LE30 million. administrative support program. In addition, EFSA would develop a common While EFSA has broad authority to regulate sales practices, this risk-based supervision methodology for all NBFI. As of 2012, these goals authority does not extend to sales programs conducted through banks have been delayed and no date has been set to complete the reorganization. (bancassurance), which are subject to exclusive regulation by CBE. This is an To date, EFSA has consolidated its administrative support functions and important gap in regulatory authority as three major life insurers (including its enforcement program. Other functions, such as the inspection units in CIL, the largest by new business) gain most of their business through bank each of the former agencies continue to operate separately and creation of a sales programs. Sales practice regulation has also been hampered by the lack comprehensive risk-based inspection program has not been completed. of a vigorous enforcement program by EFSA and by CBE.48 EFSA has a total staff of approximately 850. This includes 250 in the The 2007 FSAP Update contained a number of priority recommendations Insurance and private benefit plans office; 380 assigned to capital markets; and to support the establishment of a sound regulatory framework for the Egyptian 120 to the mortgage finance, factoring and financial leasing group. The remaining insurance sector. These included restructuring the government owned insurance staff works in the consolidated support offices. There is a significant shortage companies in preparation for privatization; expanding the professional capacity of of professional staff in the Insurance and Private Benefit Plan Office, and the EFSA staff; moving to a risk-based supervision model; and establishing risk-based Mortgage Finance Office. The Insurance program includes only 90 professional and pricing that eliminates cross-subsidization of product lines. The progress since this technical staff. This includes 30 professional and technical staff in the insurance FSAP report has been limited. inspection group and 25 inspection staff assigned to pension inspections. Lack of competition has been a chronic problem in the insurance sector. EFSA has broad authority to bring criminal (not civil) proceedings The Egyptian insurance sector continues to be dominated by three state- for violations of all laws for which EFSA is responsible. Investigations and owned insurance companies. In 2007, the government consolidated the three prosecutions require authorization by the Chairman of EFSA. The EFSA companies, along with the national reinsurance company, as a first step in the enforcement unit has approximately 30 staff; 20 are attorneys. EFSA may privatization process. In 2011, the government separated the life insurance issue subpoenas for documents to any company or entity that it regulates. and non-life insurance programs into separate companies. No date has been It has no authority to issue subpoenas to unregulated parties, which is a set for the third phase privatization of the life and non-life companies. To power found in many jurisdictions that enables a regulator to effectively promote competition and broaden the insurance products offered, Egypt now gather critical data in a timely manner. If a proceeding has been brought for permits foreign insurers to be licensed and foreign individuals to be officers a violation of the Capital Markets Law, the Chairman of EFSA may approve and directors of insurers. 190 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 191 EFSA has made progress in rationalizing premiums for mandatory ϘϘ Maximum 10 percent of fund assets in one company (stock and debt) motor vehicle third party liability insurance (MTPL). Historically state- or 20 percent of the company’s capital, however affiliated companies owned insurers cross-subsidized MTPL by charging higher premiums on other are not consolidated for this requirement insurance products and by understating liabilities in order to lower reserve ϘϘ Maximum 10 percent in real estate, and maximum 3 percent in a requirements.49 This distorted competition with private insurers. In 2007, a single property Prime Ministerial Committee authorized an increase in MTPL premiums (by ϘϘ Maximum 25 percent in member loans and no single loan may exceed approximately 60 percent of the gap) and Law 72 of 2007 capped future claim 75 percent of the value of the members benefit payouts (which had been uncapped). In addition, a Prime Minister’s Decree ϘϘ Maximum 10 percent in bank deposits in local or foreign currency established a notional defendants fund for hit and run victims. Following these reforms, private sector insurers began entering the MTPL market for with banks licensed by the Central Bank to operate in Egypt. the first time. However, the lack of a comprehensive national data on vehicle ϘϘ Maximum 10 percent in other investments approved by EFSA. claims makes it difficult to effectively calculate risk-based pricing of MTPL EFSA regulation of pension funds suffers from inadequate professional premiums and difficult for EFSA to conduct risk-based regulation of the resources and serious gaps in its statutory authority. As with the EFSA insurers insurance program, EFSA requires more trained inspection staff and more The creation of EFSA was intended to address two critical trained actuaries. DB plans are required to have an actuarial evaluation at recommendations in the 2007 FSAP–increasing professional resources and least once every five years, with large schemes are examined yearly. EFSA adopting a risk-based supervision program. Neither goal has been achieved. can require an actuarial evaluation by external examiners, paid out of fund The insurance program continues to suffer from insufficient trained assets. Unfortunately, this is difficult to achieve as most of the 600 private professional staff and the risk-based supervision program has yet to be funds rely on the two EFSA-employed actuaries for actuarial services. The developed. EFSA has only 30 inspection staff responsible for both insurers lack of authority over private pension funds that are not funded in part by and private benefit plan programs.50 A lack of properly trained actuaries is employee contributions is a serious regulatory gap. a critical problem for EFSA and for the insurance sector in general. EFSA The gaps in the law also contribute to serious deficiencies in the reports that there are only 19 actuaries in the country.51 EFSA believes that management and solvency of private pension funds in Egypt. A non- it has too few staff, and too few trained staff, to adopt a risk-based supervision professional board of directors manages private funds. The pension fund program. Without actuarial staff, insurers cannot be relied upon to develop members elect members of the board and the board selects the chairman. sound risk-based internal processes and EFSA cannot rely upon the data The members of the board of directors are personally liable for their actions provided by insurers to develop a risk-based inspection program. concerning the fund management. Typically, board members are compensated for each day they participate in fund activities. Under existing law, pension Private Benefit Fund Regulation funds are not permitted to outsource fund management responsibilities or EFSA regulates only a segment of the private benefit fund sector. Under invest in common or pooled vehicles. This means that the very large number Law 54 of 1975, EFSA regulatory authority is limited to private plans in which of small funds cannot hire professional portfolio management and must rely the employees/beneficiaries contribute to the program. EFSA is responsible upon internal staff. for supervision of 632 private pension funds (including funds that are limited As might be expected, funds tend to be very conservatively invested. to death and disability payments) with 4.7 million members and LE 26.7 Notwithstanding the statutory investment diversification parameters, billion in assets.52 Benefit funds based solely on employer contributions are private funds are 95 percent invested in government debt and bank deposits. not regulated. Private pension funds are typically described as DB plans even The strong preference for safety over performance may be heavily influenced though benefits are not guaranteed.53 by the personal liability imposed on fund directors. Law 54 of 1975 and EFSA regulations establish a broad framework for asset The prohibition on outsourcing fund management or pooling investments investment. The regulation on investments establishes the following limits: contributes to very high expense ratios for funds, which are not disclosed ϘϘ Minimum 25 percent in government bonds to fund participants. The 2002 FSAP indicated that typical expenses range ϘϘ Maximum 15 percent in corporate bonds from 5–25 percent of contributions. As a consequence of overly conservative ϘϘ Maximum 25 percent in equities investments and very high expense ratios, most investment portfolios have not kept up with inflation rates. They are unlikely to keep up in the future. ϘϘ Maximum invested in a single bond (non-government) or single stock This creates a strong likelihood that many pension funds may be unable to must not be more than 5 percent of the fund’s assets pay the benefits that beneficiaries anticipate. 192 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 193 The lack of sound data or properly trained staff at EFSA and in the amounts in relation to a borrower’s income. In 2011, EFSA proposed industry makes it difficult to project the financial health of the industry or increasing the ratio to permit borrowers to obtain mortgages in which the the extent of the shortfall. The 2002 FSAP indicated that EISA (EFSA’s monthly payment equals 40 percent of the borrower’s income. EFSA is also predecessor) estimated that almost all private insurance funds were not fully responsible for supporting the development of a model real estate registry funded and that many of them may be technically insolvent. In the 2007, system for Egypt’s new urban communities. FSAP Update EISA estimated that only 34 funds were in a poor funding EFSA, pursuant to Presidential Decree No. 4 of 2003, is responsible for position, but acknowledged that the problem may be more widespread, administration of a mortgage finance subsidy and guarantee fund providing especially among funds not supervised by EISA. EFSA has issued instructions financing support for construction of low-income residential units. The fund requiring all private pension funds to report on their funding levels. A 2007 can provide financing of up to LE 95,000 per unit. EFSA, also, oversees the EFSA survey of 177 funds, representing more than 50 percent of assets under Egyptian Mortgage Refinance Company (EMRC). EMRC was established management, showed that approximately half were underfunded. These in 2006 to provide long-term financing to mortgage finance companies survey estimates could not be independently validated. and banks by purchasing loan portfolios and issuing securitized bonds. To Legislation to update and reform the Egyptian private pension fund law facilitate securitization of mortgage loans, EFSA is responsible for developing has been drafted, but no action has been taken for several years. Proposed standardized mortgage finance terms and agreements. The 2007 FSP update amendments to the law would address the gaps in EFSA authority, would found that there has been substantial progress in developing the legal and require fund managers to be professionally qualified, would create a fit and institutional foundations for mortgage finance, the Capital Market Law proper standard for fund managers and board directors, and require a funded was amended to provide a legal foundation for securitization of mortgage pillar requirement. The proposed amendments would permit outsourcing portfolios and other pools of assets. fund management and the use of common funds, including life insurers to offer these services. Because the proposed amendments would require funds Capital Markets Regulation to have professionally qualified fund managers, it is anticipated that small Egypt has the oldest capital market in the MENA region. The Egyptian plans would outsource the asset management function. Exchange (EGX) was created by the consolidation of the Cairo Stock Exchange New funds would also be required to be defined contribution plans (founded in 1903) and the Alexandria Stock Exchange (founded in 1883). At only. The amendments would require funds to comply with a solvency margin one time (1940’s) the combined exchanges were the fifth largest in the world. equal to 10 percent of actuarial reserves. In addition, funds would be allowed After a dormant period from 1961–1992, the exchanges were revived as part to increase benefits only after the fund complies with the solvency margin. of a national privatization program.54 As described in Chapter 5, Egypt has To deal with the early retirement issue, EFSA would require actuarially fair devoted considerable effort and resources during the past two decades to adjustment in benefits. building its capital markets. While its equity market has grown significantly, its fixed-income market has not grown to the same degree. EFSA has broad, The 2007 FSAP update described the proposed changes in the pension but incomplete, regulatory authority over all aspects of Egypt’s capital law positively and recommended that enactment should be made a high markets and the businesses and individuals that it comprises. This section priority. Notwithstanding general support for the reforms, no final action will highlight key features of the regulatory system, including those aspects has yet been taken. that could be improved and strengthened. Mortgage Finance Regulation Regulating Corporations and Other Entities that Issue Securities The Real Estate Finance Law 148 of 2001 and the Financial Leasing EFSA has a complex system for regulating the initial offering and sale provisions of Law 95 of 1995 provide EFSA with a broad range of legal of securities - both equities and fixed-income. A hybrid system combines responsibilities for regulation of mortgage financing, securitization, financial disclosure-based and merit-based regulatory concepts. leasing and factoring. Banks, mortgage-financing companies, trusts, insurance companies and other companies participating in the mortgage EFSA and EGX both have regulatory authority over Egyptian sector must be licensed by EFSA. In addition to regulating mortgage finance companies with publicly traded securities. Under the Capital Market Law, companies, EFSA has responsibility for overseeing mortgage brokers, EFSA has primary authority over any offering of securities by a corporation, appraisers, foreclosure agents, credit rating and credit reporting companies. responsibility for periodic disclosure regulation, and corporate governance. EFSA has established a licensing process for each type of participant. EGX, through its listing requirements imposes minimum standards for companies traded on the EGX. It also has primary responsibility for the EFSA has broad authority to establish industry standards for mortgage secondary offerings of securities. EGX and EFSA both review applications lending. For example, EFSA regulations set a maximum ratio for mortgage 194 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 195 to list existing shares on the EGX. If the company is a bank, the offering Corporate Governance Regulation must also be reviewed by the CBE. In order to offer and sell securities, a EFSA has the authority to review and regulate corporate governance corporation must file a notice (prospectus) with EFSA. The notice must practices. Listed companies must have a Board of Directors and a majority of include a summary of three years of audited financial statements (or from the the Board, including the Chairman, must be independent directors. All items date of the company’s creation if less than three years). Following approval on the agenda for the company’s annual general assembly of shareholders by EFSA, the company must publish in two newspapers a summary of the meeting must be submitted to EFSA prior to the meeting. The general prospectus fifteen days prior to commencing the offering. assembly invitation by the board chairman must be preapproved by EFSA The issuance of new shares requires a fairness valuation by an if the agenda comprises any proposals pertinent to the capital structure independent consultant. The fair value price set by the consultant is the of the company such as stock splits, capital increase, cash dividends…etc. maximum price at which the shares may be sold. Debt securities offerings All transactions in company stock by officers and directors of the company must comply with several additional requirements. The offering must be must be approved by EFSA and disclosed to the EGX prior to execution. The approved by the general assembly of the company and the company must information is published by the EGX. obtain an investment-grade credit rating for the offering.55 In addition, a EFSA has the power to override resolutions passed at the general company must create a bondholder’s committee to represent the interests assembly meeting that benefit certain categories of shareholders or provide of the purchasers after the issuance EFSA has adopted shelf registration special benefits to board members. Shareholders representing at least 5 permitting partial sales over a one-year period. EFSA must complete its percent of a company’s capital can file a complaint with EFSA within 15 days review in two weeks, unless it requests additional information. EFSA may of the general assembly meeting and request EFSA action. Shareholders also take two weeks to review each tranche of the offering. EFSA staff review with 5 percent or more may also add items to the general assembly agenda. all offerings. Following this review a recommendation is submitted to the Tender offers for 15 percent or more of a company’s stock must be EFSA Financing Committee, consisting of five senior employees of EFSA and submitted to the company and EFSA and announced publicly two weeks headed by the Assistant Chairman of EFSA. The EFSA Board takes final before purchase of shares. All mergers and acquisitions transactions require action. The EFSA Financing Department has ten professional staff, including a price fairness opinion from an EFSA licensed financial advisor, even if the six accountants, three lawyers and one economist. transaction does not involve related parties. IPOs must reserve 10 percent for free float. The remainder of the Additionally, EFSA’s autonomous unit the Egyptian Institute of offering is typically placed with large investors through a book-building Directors periodically issues a Corporate Governance Code, a 2014 release process. Upon completion of the offering, there must be a minimum of 100 is currently being finalized in consultation with various experts and listed shareholders and a free float of 5 percent of the company total stock. Listed company representatives. companies must file annual, semi annual, and quarterly financial statements (balance sheet, income statement, cash flow statement, stockholders’ equity, Accounting and Auditing Regulation and notes to financials) with EFSA and the EGX. A summary of the annual Egypt has adopted IFRS and IAS However there are several significant and semi-annual reports have to be published in two daily newspapers, at variations in Egypt’s interpretation and application of IFRS. Specific areas least one of which is in Arabic (Capital Market Law 6 and 7) within three of variation include related party transaction accounting, accounting for months of closing. Quarterly reports, with audited financials, are filed employee benefits, and valuation of long-term assets (historical cost), lease within one month of closing. Moreover, in addition to the annual financial accounting, and the treatment of reserve accounts. Banks and insurance statements, companies have to file with EFSA the annual board report and companies in Egypt do not mark-to-market investment assets in practice the auditor’s report one month before the general assembly meeting. Registration requirements for accountants could be more robust. Any EFSA has a department that reviews all company reports. The person holding a university degree with 5-years’ experience can be registered department has thirty accountants on its staff. Following its review, EFSA as an accountant and allowed to audit corporations. There are currently may provide a company with comments and direct the company to amend the 16,000 registered accountants. However, the Egyptian Society of Accountants, report. If the company does not comply with required modifications, EFSA a private professional association, has set more stringent registration may publish its remarks and required amendments in daily newspapers at conditions for its members. They are required to pass selective examinations company expense. Later filings, including documents that are late due to and complete a three-year training program with a recognized audit firm. EFSA requests for additional information, are subject to a fine of LE 2000 per At present, the Society is composed of 1,200 members. Accountants who are day. Company reports are publicly available at EFSA for five working days. members of the Society audit an estimated 80 percent of listed companies. 196 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 197 Law 123 of 2008 created an Auditors Oversight Board (AOB). The AOB The Capital Market Law imposes a wide range of customer protection is responsible for licensing auditors and creation of a quality control program requirements on licensed brokerage firms. These include a customer to periodically review audit firm practices. The law empowers the AOB suitability (“know your customer”) requirement, record keeping requirements, to require firms and companies to submit documents and other materials and operation of an internal compliance program. EFSA is also authorized to needed for quality control examinations. The AOB is also authorized to work arbitrate disputes between customers and broker.The executive regulations with professional organization to recommend changes in Egypt’s accounting of the Capital Market Law state that dealing/market-making activity must and auditing standards. Any proposed changes to these standards must be be conducted through a separate EFSA licensed company. There are no submitted to EFSA for action. EFSA, in turn, must make a recommendation market-makers licensed in the Egyptian market to date. to the line ministry (currently the Ministry of Investment) to issue the Brokers rely upon commission fees and margin loans for revenue. proposed standards with a ministerial Decree. To date the AOB has played EFSA permits margin lending for the purchase of designated eligible “liquid” a limited role. The quality control review process envisioned in Law 123 of stocks. Currently 83 EGX stocks are eligible collateral for margin loans. 2008 has yet to be established. Clients interested in borrowing from brokers to purchase non-marginable The Egyptian Association of Accountants (EAA) has a voluntary testing stock are frequently provided with “overdraft” protection by brokers. Some program to certify accountants and auditors. Individuals with three years of brokers apparently provide overdraft protection for an extended basis to relevant experience may be licensed as an accountant or auditor. The CBE favored clients. In addition to violating EFSA limits on margin lending, it requires five years’ experience to serve as a bank auditor. may create significant risks for other clients, as the cash used to purchase Audit attestations must be signed by an individual and not by a firm. the securities may be withdrawn from the omnibus account for client funds. Listed company financial statements must be signed by 2 auditors. Any In the event of a brokerage default that necessitates emergency action, disagreement between the auditors must be disclosed, including the subject EFSA would be unable to immediately protect client accounts. For example, of the disagreement. if the broker is suspended or its operations limited, clients would have to individually transfer their account to another firm. If this occurred during a Brokerage and Intermediary Regulation period of market volatility, clients may be harmed by an inability to execute EFSA has broad authority to license and regulate market intermediaries. trades. The international best practices approach is to authorize a regulator, All brokerage firms must be licensed by EFSA and be a member of the EGX.56 an exchange or a court to appoint a temporary receiver or custodian who is Under the Capital Market Law, an intermediary must be a corporation or empowered to take action to protect client assets. partnership. Firm officers and directors are subject to a “fit and proper” EFSA is responsible for licensing and regulating mutual funds, venture review by EFSA and shall not have been convicted of a crime or misdemeanor capital and private equity firms and the managers of these entities. There are during the preceding five years. EFSA has the authority to issue regulations 73 mutual funds in Egypt, managed by 21 fund managers (38 fund managers on sales practices, internal compliance procedures, and capital adequacy. are licensed). The mutual fund sector has grown steadily over the past EFSA regulations specify that brokers must have minimum paid-in decade. In 2001, there were 22 local mutual funds with total assets under capital of LE 5 million (Part 2, §125). EFSA regulation 68 of 2010 requires management of LE 3.9 billion, managed by nine fund management firms. increased paid-in capital for firms with branch offices–LE 500,000 for each As of the end of 2010, total assets under management for equities open-end class II branch and LE 1 million for a class I branch. An additional LE 100,000 mutual funds were approximately LE 9 billion. This includes LE 509 million is required for additional marketing branches. invested in eight Islamic funds. As of the end of 2010, the three closed-end Brokerage companies must obtain licenses to perform specialized activities. funds had a combined NAV of slightly more than LE 3 billion. Profits from Specific license is required to engage in the following activities–margin trading, mutual funds are tax-exempt. Several offshore funds managed by Egyptian short selling, on-line trading, intra-day trading (by customers), and customer fund managers are significant investors in Egyptian capital markets. As of custody. “Market need” is one of the factors considered by EFSA in approving 2008 (last figures available) there were 17 licensed venture capital firms. licenses (Part 2, §127). In practice this has resulted in EFSA declining to license Mutual funds must be structured as joint stock companies, supervised new firms and the total number of licensed firms has changed only marginally by a Board of Directors. A majority of the Board must be independent of the in more than a decade–146 in 2001 and 148 in 2010. Also, because EFSA cannot managers and originators of the fund and may not be investors in the fund. revoke a license due to the inactivity of a brokerage firm, a dormant or defunct EFSA may remove Board members or fund officers by written decision (§39). firm can maintain its license in the hope of selling it to a new entrant that is Only CBE-approved banks and EFSA-approved insurance companies may unable to obtain a license from EFSA because of the lack of a “market need”. As a create mutual funds without establishing a separate fund joint stock company. result, there are a significant number of licensed but dormant firms. All funds must have an internal compliance officer, an internal auditor, and 198 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 199 two external auditors (individuals). The internal controls officer must notify EFSA reviews the mutual fund prospectus and periodic reports. EFSA weekly of any unresolved customer complaints, any violations of the EFSA staff must review the prospectus prior to initial sales. The prospectus law, regulations or Decrees, and any internal control violations not resolved must contain information on fund investment strategy, expenses, valuation by the fund administrator within 1 week. Both external auditors must sign procedures, and purchase and redemption procedures. EFSA considers the the funds financial statements. qualifications of officers, directors and fund managers as part of its initial The Capital Market Law requires that mutual funds have separate review process. The CEO, fund manager and compliance officer must pass originators, managers and custodians. A bank custodian, regulated by the CBE, an EFSA qualifications review (interview). Mutual funds are required to file must hold fund assets in segregated accounts. The creator of the fund must with EFSA quarterly and annual reports, both containing externally audited initially invest in the fund an amount equal to 5 percent of the fund’s assets. As financial statements the fund grows in size, the creator must increase this investment to maintain MMMFs may invest only in short-term liquid fixed-income securities. its 5 percent interest, until it reaches a maximum investment of three times its The maximum maturity for any security is 13 months and the maximum initial investment. Fund assets may not exceed 50 times the originators paid-in average weighted maturity of the fund assets is 150 days. No more than 10 capital. EFSA intends to amend its executive regulation and lower the initial and percent of fund assets may be invested in securities of one issuer (other than maintenance investment amount to 2 percent of the initial fund size. the government). The MMMF’s Board must set and disclose the minimum EFSA regulations impose diversification requirements on fund investment grade of investments, which may not be lower than BBB. Mutual investments. A fund may not invest more than 10 percent of its assets in a funds provide limited disclosure to investors. While MMMFs must calculate single company, including related affiliates. In addition, a fund cannot own NAV on a daily basis, other mutual funds are required to calculate NAV and more than 15 percent of the total shares issued by one company. A fund may publish in newspapers on a weekly basis. Funds are not required to publicly not invest more than 20 percent of its assets in another mutual fund or own disclose any information on the actual fund holdings, even in summary form. more than 5 percent of another mutual fund. Investments in other funds, EFSA Oversight of Self-Regulatory Organizations except MMMFs, must be in unaffiliated funds. A fund may not invest more than 20 percent of its assets in an affiliated company or in the debt (including EFSA has broad oversight authority over two SRO - the EGX and commercial paper and short-term notes) of any one company. Funds are not the MCDR. Law 10 of 2009 creating EFSA provided broad authority for permitted to engage in short selling or buying on margin. Funds may not controlling and supervising NBFIs, markets and instruments, including trade with affiliates of the fund originator or fund manager. Finally, funds capital markets. Presidential Decree 191 of 2009 governs the governance and may not invest in an entity where it would have unlimited liability. supervisory powers of the EGX and Presidential Decree 192 of 2009 provided EFSA with regulatory authority over the EGX. EFSA must review all SRO Mutual funds are required to keep an unspecified amount of the fund’s rules concerning listings, member regulation, trading and clearance and assets liquid to satisfy anticipated redemptions. If the liquid funds are not settlement. EFSA and EGX Chairman have the authority to halt trading on sufficient to meet redemption requests, a fund may borrow up to 10 percent a single stock and accordingly all stocks. of fund assets for a maximum of one year, with Board approval. Mutual funds apply different fair value pricing techniques. Mutual funds must adopt The EGX has an ambiguous legal status. It is wholly owned by the Egyptian a procedure for valuing assets where a market price is not available. In a government and has an independent status but it is not a corporation. It is market such as Egypt in which a significant number of stocks do not regularly governed by Presidential Decree No. 191 of 2009 and subject to oversight by EFSA. trade, the fair value accounting method selected can have a significant effect The Prime Minister appoints the Chairman and Vice Chairman of the EGX. The on NAV and reported fund performance. Governor of the CBE appoints one member. The remaining members are elected among member firms and listed companies. EGX has primary responsibility for Investments and redemptions are calculated on the basis of the next market surveillance. It has a full-time market surveillance staff of 12. While day’s NAV. Redemptions must be paid within two working days. A fund may both EGX and EFSA may order halts or suspensions in trading in a listed stock, only suspend redemptions for exceptional circumstances. This requires prior the EGX typically takes action. In addition to monitoring unusual trading in Board approval and prompt notification to and prior approval of EFSA. EFSA EGX listed securities, it also monitors whether prohibited persons are trading does not directly regulate mutual fund sales practices and personnel. EFSA MCDR. It has the authority to suspend suspicious trading MCDRuntil requested does not review fund sales materials, other than the prospectus. In addition, information on beneficial ownership is provided. it does not license or supervise sales personnel. The majority of mutual fund sales occurs in bank branches and is under the authority of the CBE. While EGX conducts its self-regulatory functions through a listing committee employees of brokers are subject to suitability and “know your customer” and a membership committee. The EGX membership committee is responsible requirements, bank employees are not subject to these standards of care. for overseeing member brokerage firms. EGX staff review daily capital 200 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 201 adequacy reports from all member firms. When a firm’s net liquid capital falls Legal and Institutional Framework below 110 percent of its risk-weighted capital, it must provide EFSA with an A clear, fair and effective legal framework is an essential prerequisite explanation and a plan for increasing its capital. EFSA may suspend a firm if for a modern and efficient financial sector. This framework should include it falls below its minimum capital. They also monitor other firm’s activities; a comprehensive corporation law, laws governing contracts and commercial including internal compliance, margin lending, segregation of customer transactions, bankruptcy laws and debtor-creditor rights and obligations, and accounts, and sales practices and customer service. EGX performs these uniform accounting and auditing standards. However, a well-designed legal and functions by reviewing member firms’ reports and books and records. No on- regulatory framework is not enough for a sound and efficient financial system. site inspections are performed. EGX has limited enforcement and disciplinary It needs to be complemented with an adequate and supportive institutional authority over its member brokerage firms. EGX has the authority to impose infrastructure to ensure enforcement. For example, an effective framework should non-monetary sanctions on its members and their employees for violation include credit-reporting services, legal registries to perfect lending agreements, of EGX rules. It may issue warnings or impose time-limited suspension. and generally accepted standard forms of agreements. Most importantly there Any sanction imposed may be appealed to EFSA for review. EGX may also must be an educated and well-staffed judiciary of the highest integrity. consider complaints against members received from customers and can direct firms to compensate customers. During the past decade, a number of improvements were made to the applicable laws in Egypt and several institutional changes were initiated. MCDR is the only CSD in Egypt. It began operations in 1996 as a not While these changes represent an improved environment, large gaps in for profit corporation, licensed under the Capital Market Law No. 95 of 1992 the law and the implementing environment continue to exist. Some of the and subject to the CSD and Registry Law 93 of 2000. MCDR is jointly owned laws are poorly written or out of step with modern financial transactions, by sixteen banks (50 percent), eighteen brokerage firms (45 percent) and especially those applicable to secured transactions, bankruptcy, and the the EGX (5 percent). No company (and its related parties) may own more settlement of disputes. In addition, many of the new laws remain untested. than 5 percent except for the EGX. It is managed by a CEO who Chairs Collateral legislation is both inadequate and poorly enforced. Property-rights its Board of Directors with equal representation from banks, custodians and registration and titling issues make it difficult for firms, especially small and brokerage companies, plus one representative of the EGX. MCDR provides medium size firms, to use land assets as collateral. Moreover, even when clearance, settlement and depository services. EGX equity trades settle on collateral is registered, there is no information on its value. a T+2 cycle. The settlement cycle for debt and unlisted securities is subject to bilateral agreement of the parties. Settlement is on a DVP basis with Delay and inefficiency in the judicial system continues to exacerbate the ownership transferring on settlement date. The securities leg is settled on a problem and hinder lending. Legal proceedings are slow and cumbersome, and gross basis, while the cash leg is settled through the CBE on a net basis. The often drag on for several years. This deters banks from initiating bankruptcy MCDR processes all EGX trading and acts as a central depository of EGX- and foreclosing procedures on defaulters. There are also no specialized judges listed securities, as well as unlisted securities should the companies opt for with knowledge of financial markets or credit risk issues; this affects the depositing its securities with MCDR. It is not a central counterparty (CCP) quality and reliability of decisions. and is not a custodian. While MCDR is not a custodian, it records securities In the current political environment, it is unlikely that the commercial ownership in the name of the beneficial owner, as well as the name of the laws of Egypt will be a high priority in the near future. However, legal bank acting as custodian and its records serves as the definitive register of modernization and reform is essential to future private sector economic shareholders. It is responsible for payment of dividends to beneficial owners development and for continued development of the national financial sector. and providing notices to investors. The reform efforts of the previous decade should be seen as a foundation MCDR operates a settlement guarantee fund (SGF). The fund covers for further improvement. In particular, there are two areas of the law that all settlement failures. It also can be used by EFSA to unwind trades that represent major impediments to developing a modern financial system: (i) EFSA determines resulted from insider trading. The fund is not responsible the law on secured transactions; and (ii) bankruptcy law and procedures. In for investor losses due to the failure of a market participant. The SGF fund addition to addressing these two impediments, improving the effectiveness has LE 200 million, with a LE 400 million back-up line of credit. Member and efficiency of the judicial process should be a third priority. These topics firms are assessed payment amounts through a formula involving the volume are discussed in greater detail in the following section. of trading plus a risk factor based on the firm’s failure rate. There is no Secured Transactions obligation on the part of MCDR participants to replenish the SGF if it is Laws that govern secured transactions are vital to the financial system of depleted or to top it up if the level is deemed inadequate in light of market a country. An effective system for secured transactions reduces lending risk by activities and risk exposures. enabling lenders following a default to recover through the sale of the collateral. 202 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 203 This in turn makes it easier for persons or companies to borrow money and I-Score, was established under the leadership of the CBE, with support from the typically to borrow at a lower cost. Secured transactions are particularly IFC and Dun & Bradstreet. It became operational in 2007 and CBE granted it a important for new borrowers, including newly established firms and those license in 2008. As of 2009, it had records on more than 4.3 million individuals and recently privatized companies with no credit history.57 Egyptian law recognizes 43,000 SME.59 Virtually all banks and NBFIs are contributing credit information three major forms of security: mortgage, pledge, and business charge. to I-Score. In the latest IFC Doing Business Report, Egypt received the highest Mortgage is a secured transaction in which the borrower agrees that the possible score on the depth of credit information index (0–6).60 lender will hold legal title to the asset used as collateral until the loan is fully repaid. While these reforms have been positive, many aspects of Egyptian law on While a mortgage is most frequently used when real estate (immoveable property) secured transactions require further reform. The traditional limitations that are is the security, in Egypt ships and aircraft may also be mortgaged. The Civil Code embedded in the three forms of secured transactions have restricted the development of 1948, Articles 1030–1084 and 1096–1129 govern mortgage loans. The code was and use of a variety of modern secured transactions to finance commerce that are in amended by the Real Estate Finance Law 148 of 2001 to provide that banks may seize widespread use globally, such as leasing and factoring. Although several legal reforms mortgaged property in the event of a default even if the borrower has other assets. were adopted to address these limitations, the results have been mixed. For example, The 2001 amendments authorize five types of entities to engage in mortgage lending: Egypt’s first leasing Law 95 of 1995 was amended in 2001 to enable companies to banks, mortgage finance companies, trusts, insurance companies, and other entities use leases to finance the purchase of vehicles for passenger transportation. However, that EFSA licenses to offer mortgage loans. These amendments also authorized the this reform did not address the problems of enforcing ownership rights such as the use of securitization for pools of mortgages. While the use of mortgages has increased frequent delays and high legal costs in collecting overdue payments. This has led since 2001, the process of perfecting a mortgage continues to be costly and complex. the industry to move towards “client-based leasing”, where the decision to make All mortgages must be evidenced before a notary. The doctrine of specificity applies a leasing contract is based on the client’s creditworthiness, rather than relying on to both the mortgaged property and the secured debt. Specific identification is “often asset-based leasing.61 Factoring is a vital technique in many countries that enables inconvenient, sometimes impractical and always theoretical.”58 retail companies to use accounts receivables as collateral for loans and lines of credit Pledges are secured transactions in which the borrower retains legal title that can serve to address operating cash flow difficulties. to the asset but the lender (or a designated third party) acquires possession. As The lack of a centralized property register continues to be an important such a pledge is unsuitable for any transaction in which the security is a useful infrastructure deficiency. Because mortgages continue to be registered with a or productive asset (such as manufacturing equipment). These transactions are local notary public, it is difficult for secured lenders to adequately protect their governed by Articles 1096 - 1129 of the Civil Code. There are two other important interest and enable others to confirm its existence. Overall, the rights of creditors drawbacks to using a pledge under current law: (i) the law only recognizes are not well served under current Egyptian law. The annual IFC Doing Business possessory pledges of movables, since non-possessory pledges of movables do not Survey found that Egypt ranks among the lowest countries (Figure 5.1). exist (under the doctrine of false wealth); and (ii) future assets cannot be pledged, since the pledged property must be adequately specified in the pledge agreement. Figure 5.1: Legal Rights of Creditors in Egypt and Other Countries 200 Business charges (also known as equitable charges in some jurisdictions) are the third form of secured transaction in Egypt. In this transaction, a borrower retains ownership and possession of the collateral and the lender 150 has a contractually guaranteed right to seize the asset in the event of a default. In Egypt, a business charge agreement must be notarized. As with a pledge, the principle of specificity applies and future assets (other than Percent 100 inventory) cannot be used as collateral. Business charges are governed by Law 11 of 1940 (fonds du commerce). Several legal reforms of the past decade appear to have achieved some 50 measure of success. For example, the 2001 amendments to the civil code in the Mortgage Finance Law have contributed to a significant increase in the availability and use of mortgages for residential property. This increase is also due in part to the 0 Algeria Syria Lebanon Bhutan Argentina Czech Cambodia Indonesia Egypt Mexico Philippines Barbados India Jordan Botswana Romania Armenia Morocco Azerbaijan Pakistan Poland Colombia Macedonia China Bangladesh Turkey Bahrain Srilanka Iran Benin UAE Belarus Croatia Thailand Bulgaria Singapore Lithuania El Salvador Malaysia Bolivia Belize Hungary Brazil Estonia Tunisia Korea Rep. South Africa USA Australia Ireland Chile creation of the EMRC in 2005, funded by loans from the World Bank and the IFC. Another promising development in the past decade has been the establishment of a national credit registry/ credit-reporting bureau. This is a critical component Source: Doing Business. of a modern secured lending infrastructure. In 2005, a national credit bureau, 204 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 205 The shortcomings of the law on secured transactions do not stop at extinguishing of debts and obligations. The rights of secured and unsecured the conceptual framework, but include how the rules on enforcement are creditors must be differentiated, and the rights of differing ownership interests, drafted and applied in practice: (i) the rules are complex by design and of management, and of employees must be recognized. The law must provide formalistic; (ii) procedures for enforcement are time-consuming (notification, for a wide range of outcomes, including continuing operation by a debtor in attachment, and sale by public auction); (iii) the process of sale is inefficient, possession, limited or comprehensive reorganization or restructurings, or resulting in modest proceeds; and (iv) private sale and strict foreclosure are liquidation. The judiciary must have broad and flexible powers to act swiftly and not permissible under law. Again, Egypt stands out internationally in this with finality. Judges must have specialized expertise in order to understand area. An index of the costs to create collateral shows Egypt to be ranked complex financial transactions and to gain the confidence of the commercial among the most costly (Figure 5.2). and financial sector. Most importantly, the public must have confidence in the impartiality and integrity of the judiciary. Figure 5.2: Cost to Create Collateral in Egypt and Other Countries The current bankruptcy law in Egypt is severely outdated and too Cost to create collateral (% income per capita) narrowly drawn. It is based upon a century-old bankruptcy code that predates 60 modern commerce. Articles 550-772 of the New Commercial Code of 1999 50 represent the most recent legal reforms since the 1960s. These amendments did not make significant conceptual changes to the Code of 1883, which 40 it replaced. They adhere to the historical perception that a bankruptcy is a violation of moral principles of trust between debtor and creditor. Also, 30 they focus on personal, not commercial or corporate, bankruptcy. Moreover, save for a solitary and ambiguous provision (Article 702), the rules focus on 20 liquidation and fail to provide any legal mechanism for reorganization. Another problem with the existing law, containing more than 200 10 articles, is that it is overly complex and time-consuming. Additional delay arises because the court plays a very active role in supervising and approving 0 all aspects of the process. Because the code is focused on liquidation as the Morocco Jordan Egypt Bolivia Colombia Mexico Tunisia Brazil Argentina Bangladesh Turkey Macedonia Hungary Pakistan India UAE Philippines Korea Rep. Syria Chile El Salvador Yemen Lithuania Ireland Malaysia Indonesia South Africa Lebanon Poland Romania Thailand Bulgaria Srilanka Czech Algeria Singapore Hong Kong Taiwan United Kingdom USA Cambodia China eventual outcome, typically the last step is the sale of the debtor’s assets via public auction, which results in only modest proceeds and is generally not beneficial to either creditors or debtors. Source: Doing Business. The deficiencies in the bankruptcy code contribute substantially to These shortcomings negatively affect the lending environment. The inefficiencies in modern commercial transactions. It is a major contributing factor inability to use moveable property as non-possessory collateral precludes to the excessive guarantees and collateral demanded by lenders, including banks many individuals and new companies from obtaining financing. Legal and NBFIs. It also severely hinders access to finance by SMEs, particularly start- uncertainties, costs and delays in enforcing a legal interest when a default ups that lack a long credit repayment history. Global comparisons demonstrate occurs affect the availability and cost of a loan. The Sale of Commercial the extent and severity of the problem. The 2012 Doing Business survey ranked Concerns Law of 1940 governing business charges fails to address the needs Egypt 139 of 185 countries in ease of resolving insolvency. According to the Survey, of those using the system. The Model Law on Secured Transactions provides average resolution time was 4.2 years and the proceeding cost an average of 22 a comprehensive template for modernizing the law on secured transactions percent of total assets. Creditor recovery averaged 17.6 percent of outstanding in emerging economies. It presents solutions to issues relating to the creation debts.62 “Scrapping the existing laws and imposing new rules for bankruptcy of a security, the forms thereof and enforcement procedures that ensure would be a significant means to rapidly facilitate access to finance for businesses, efficiency of the system and is consistent with Civil Law traditions. especially small and family-owned ones.”63 Bankruptcy Judicial System Reform A modern and comprehensive bankruptcy law is a critical precondition Laws are seldom self-executing. The impact and effectiveness of legal for an effective private sector economy. In a modern market economy, some reform depends upon the judiciary that must interpret, apply and enforce the entities will succeed and some will not. When an entity fails, the law must law. An effective judiciary must be expert in the law and judicial process and promptly address the rights of creditors and debtors, and the resolution and it must be impartial and have the highest integrity. The judiciary must also 206 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 207 understand the importance of timely adjudication and management of its docket. Concluding Remarks A judiciary needs to ensure their correct application and enforcement, or at least The Egyptian regulatory system for the non-bank financial sector has had a support their implementation. series of noteworthy accomplishments over the past decade. Notable accomplishments Figure 5.3: Dominance of Collateral-Based Lending in Egypt include the creation of EFSA, amendments to the insurance law, continued progress 200 on the reorganization of the state-owned insurance companies toward eventual privatization, promising growth in the mutual fund sector, adoption of IFRS accounting standards and reduction in the number of illiquid stocks listed on EGX. Progress has 150 been made in the past decade in strengthening the regulatory, supervisory, and legal framework necessary to support financial transactions and intermediation. There is now better market transparency, and greater availability of information, particularly credit reporting data. The legal environment and infrastructure for mortgage lending Percent 100 has improved and the Economic Court may eventually achieve the goal of greater speed in resolution and more expert adjudication. 50 The consolidation of NBFI regulators into a single regulatory agency has not achieved its objectives yet, largely because completion of the consolidation has been partially postponed. It is recommended that EFSA complete the transition from three 0 separate agencies to a single consolidated regulator. As part of the process, EFSA Syria Algeria Lebanon Bhutan Argentina Czech Cambodia Indonesia Egypt Mexico Philippines Barbados India Jordan Botswana Romania Armenia Morocco Azerbaijan Pakistan Poland Colombia Macedonia China Bangladesh Turkey Bahrain Srilanka Iran Benin UAE Belarus Croatia Thailand Bulgaria Singapore Lithuania El Salvador Malaysia Bolivia Belize Hungary Brazil Estonia Tunisia Korea Rep. South Africa USA Australia Ireland Chile should continue its efforts to improve its on-site inspection programs in all areas of responsibility and develop an internal risk-rating capacity in conjunction with its Source: Egypt ICA. transition to a risk-based supervisory program. Law 10 of 2009 should be amended to provide EFSA with comprehensive administrative enforcement authority. In Historically, the Egyptian judiciary has been criticized for excessive addition, EFSA should have the authority to take “prompt corrective action” if a firm delay, uncertain or inconsistent application of existing law, and inefficiency fails, to prevent systemic risk and to protect clients of the firm. Finally, EFSA must in taking action to enforce decisions. The consequences of these flaws were expand the number of professional and technical staff in each program. Increasing several. Civil, commercial disputes typically took three–five years for final the number of professionally trained and certified actuaries should be a high priority. resolution. Delays of this length had a substantial adverse effect on loan Investor and customer protection must be a core objective of all regulatory defaults and efforts to enforce collateral agreements. A lack of expertise in programs. In this regard, EFSA regulation of mutual funds should emphasize complex commercial transactions, coupled with antiquated laws that were not improvements and enforcement in the quantity and frequency of disclosure to fund written with modern commercial transactions in mind often led to decisions investors. Mutual funds should be required to make NAV publicly available daily that did not clarify the law or fully resolve litigated questions. The Economic and should be required to send investors updated disclosure on fund performance, Court Law 120 of 2008 was enacted to address these important problems. investment strategies and information on fund holdings on a regular basis. EFSA and The law created a new court to deal with 18 commercial laws, pertaining to CBE should develop uniform procedures for regulation of mutual fund sales practices financial transactions and banking; it was anticipated that judges assigned by bank employees. MCDREFSA should expedite the establishment of the arbitration to this court would be specially trained and would be expected to effectively center mentioned in the Law 10 of 2009. manage their dockets to improve speedy resolution of disputes. The court was Future economic development will continue to be constrained if essential divided into separate departments for government–private party disputes and legal reforms are not accomplished. It is recommended that Egypt enact a disputes between private parties. comprehensive reform of its secured transaction laws. The Model Law on Secured The success of the Economic Court Law is still uncertain. One commentator Transactions provides a comprehensive template for modernizing the law on identified anecdotal evidence “that the introduction of economic courts has been secured transactions in emerging economies. Similarly, comprehensive reform helpful”.64 According to one source, “as of November 2010 no publicized test case of the bankruptcy code, which facilitates reorganization as an alternative to had entered the economic courts.65 Because of the limited and uncertain success of liquidation, is a critical precondition to economic development. In conclusion, the Economic Courts, 92 percent of bank lending requires collateral (Figure 5.3). these recommendations on improving NBFI regulation and legal reform will not Moreover, banks engaging in secured lending continue to require a substantial guarantee future economic growth in Egypt but they will contribute measurably to ratio of collateral to loan, typically at least 60 percent of the loan amount. This a strong and fair capital market, enhanced protection of investors and the public substantial burden further restricts SME access to finance. and greater access to finance, at lower costs to borrowers. 208 Financial Development and Inclusive Growth Financial Sector Integrity and Economic Growth 209 Endnotes 23 And its executive regulations, and subsequent amendments (Law 162 of 2004, and Law 93 of 2005). 24 Often referred to as “specially mentioned” loans in other jurisdictions. 1 According to the IMF data base on Financial Access Survey (FAS). 25 These indicators mainly cover economic growth, balance of payments variables, inflation, interest and 2 Factors that appear to have contributed to the attraction of bank deposits are (1) the explicit (though not exchange rates, trends in lending, and asset prices. “funded”) deposit guarantee of the government for state-owned banks, and now also private banks; (2) reasonably attractive interest rates on term and savings deposits, even if often negative in real terms given 26 Of 1988, amended, in particular, in 1996 to incorporate market risks. the persistent inflation; and (3) the perceived lack of other “safe” instruments of store of wealth. 27 Specifically, the core capital (Tier I) consists of the paid-up capital, reserves and retained earnings. 3 However, the number of bank depositors per 1,000 adults (only about 440) is less than in most comparators Supplementary capital (Tier II) is composed of the general provisions, the subordinated borrowing of more (600 on average in the MENA region, and more than 1,500 on average in emerging Asia), which is evidence than five- year maturity (provided that 20 percent of the value of these loans is amortized in each year of the of a persistent gap in the access to banking services. The number of bank branches per 100,000 adults (about last five years of their maturities), 45 percent of the difference between the market value and the book value 8) is among the lowest in the world, and so is the number of ATMs (about 9). Noteworthy, is the importance, of long term investments. The supplementary capital should not exceed 100 percent of the core capital, and outside the banking system, of Egypt Post, which serves over 17 million clients through 3,700 outlets subordinated debt should be limited to 50 percent of Tier I capital. country-wide. It offers payment and deposit services, including savings accounts, but no credit facilities. 28 See CBE decision of October 2, 2007, op. cit. There is little doubt that some form of integration of Egypt Post, or parts of it, within the banking system would offer the promise of a dramatic extension of financial services. 29 See CBE decision of January 6, 2009. 4 That regulation is common elsewhere, and based on sound prudential considerations. 30 BIS (2006, 2009). 5 See World Bank (2010). 31 Under Basel II, the threshold for significant would be 15 percent of the bank’s capital for individual significant investments in commercial entities, and 60 percent of capital for the aggregate of such investments. 6 Which include consumer loans (credit card, auto, and personal loans), personal housing real estate loans, and small enterprise loans. 32 BIS (2011). 7 World Bank (2010). 33 Seven maturity buckets are to be considered: following day, 1 week or less, over 1 week to 1 month, over 1 month to 3 months, over 3 months to 6 months, over 6 months to 1 year, over 1 year. 8 Reportedly, two mobile phone companies have recently been granted a license to operate mobile phone banking, but the start of their operation has been delayed. 34 The CBE has recently been updating the rules applicable to those experts registered with the CBE for the purpose of attesting the value of collateral and guarantees on bank loans. 9 Nevertheless, for the banking system as a whole, improved efficiency indicators have underpinned the upward trend in profitability. In particular, the ratio of operating expenses to net income has been on a 35 Credit cards, personal and auto loans, and real estate loans for residential housing. declining trend in recent years, falling to well below 40 percent, now more in line with best international 36 These include loans to artisans, professionals, and youth projects, as well as to firms generating less than outcomes, while the ratio of net income to personnel expenses has almost doubled in the period under LE 1 million in annual revenue (i.e. micro-businesses under CBE classification). review. In addition to a stronger, developing, and more diversified banking sector there has been a decline 37 The growth since 2005 was rapid, but this is because it started from an almost non-existent baseline. in recent years in the interest margin component of total income. 38 A maximum financing ratio of 90 percent, a limit of 10 percent of the financier’s capital for any single 10 A comprehensive earlier analysis of the nexus between access to finance and growth in Egypt is provided borrower and its related parties, and a limit of 40 percent of the borrower’s total gross income for income in World Bank (2007). brackets other than low income brackets. 11 Regulations on “Preparation and Presentation of Banks’ Financial Statements, and the Principles of 39 See World Bank (August 2011). Recognition and Measurement”; available on the CBE website in Arabic. These rules became fully effective on January 1, 2010. 40 The rules for MBS holdings and permissible leverage ratios need to be further developed and standardized, as does the securitization infrastructure (rating agencies, external source of credit enhancement). 12 In consulting the English language websites of various banking groups, it would appear that even Annual Reports are sometimes not prepared on a consolidated basis. 41 See also World Bank (March 2011). 13 World Bank (August 2011). 42 Special regulations on credit to real estate development companies were introduced by the CBE on October 2, 2007, with a view to reducing the risks associated with this activity. In particular, these companies were 14 See World Bank (March 2011) flagship paper for an assessment, region-wide, of these issues. obligated to establish a special account for each project, which allowed for the transparent calculation of 15 Additional corporate governance and disclosure requirements have been included in a recent draft regulation, a financial leverage ratio, defined as the project’s liabilities, including financing and down-payments from awaiting Board approval. They cover remuneration and compensation policies, risk management, and reserving clients, divided by the company’s funds allocated to the project. The latter is also used in the further rules on Board member qualifications. calculation of the required risk-weight for the purpose of calculating capital adequacy. 16 The latter includes 3 state-owned commercial banks (which basically have a sovereign rating). Even 43 For an excellent analysis of these problems and their implications, see de La Torre and al. (July 2008), and excluding the 12 banks that are either wholly-owned subsidiaries or branches of foreign banks (generally Beck and Al. (November 2008). listed on other markets and rated globally), this leaves 15 banks not listed anywhere, and 18 banks not rated 44 World Bank (2010). by any international credit rating agency. 45 Besides the regulations governing small loans for economic activity referred to earlier, and which include 17 This judgment is based on a web-based analysis of the current state of the banks’ disclosure practices in Egypt. loans to firms with a maximum business size of LE 1 million (i.e. micro-finance loans under the CBE criteria). 18 The CBE Board of Directors approved on January 6th, 2005, set the rules regulating the work of credit 46 Buyer of inputs subject to a Trust Receipt pledges to the bank the inputs it has purchased, but is authorized bureaus and the exchange of information. to transform them into final products, while the bank retains its interest. 19 For banks, there is a one-time fee of US$10,000, and annual fee of US$10,000 as well; for non-bank, these 47 See for instance the SME regulatory framework introduced by the State Bank of Pakistan. fees are US$3,500. There is also a fee charged per credit report. 48 Recognizing the importance of this area, CBE has imposed a freeze on any new bancassurance agreements 20 The requirement is LE 500 million for a domestic bank, and US$50 million for a branch of a foreign bank. until applicable rules are strengthened. Levels observed in other countries are now often in the US$ 20 – 60 million range. 49 Mandatory profit sharing by officers, directors and employees of state-owned insurers may influence 21 See Poshakwale and Binsheng (March 2011). decisions on reserve provisioning. Egyptian law provides that officers and directors of state-owned insurers 22 This program was funded by the EU under a technical assistance program agreed with the European Central receive 5 percent of company earnings and employees receive 10 percent. This may influence decisions on Bank and four European central banks. Resident advisors from the ECB assisted with the implementation. the size of company reserve accounts. The Department currently has eight divisions: On-site Inspection, Off-site Monitoring, Regulations, 50 EFSA, with US AID’s assistance added a program to strengthen its pension supervision capacity. As part Licensing, Basel II Implementation, Central Credit Registry, Legal Cases, and Macro-Prudential divisions. of its training program, thirteen of thirty inspection staff have been sent to other countries for training. The Department is headed by a Sub-Governor of the CBE, and is represented on the CBE Board by one of the two Deputy Governors. Heavy emphasis has been placed on recruiting the best qualified managers, and 51 Because of the shortage, the four trained actuaries at EFSA also work part-time for regulated insurance upgrading the information systems making use of the latest technology. The quality of the staff has been companies and pension funds. EFSA has worked with Cairo University on developing a program to train enhanced, with Senior Management of the CBE placing great importance on capacity-building and training. persons to become actuaries. New internal guidelines supporting risk-based supervision have been put in place, including for IT use. A 52 The large number of private pension funds is deceiving as the 25 largest private funds control roughly 50 data warehouse conforming to international standards is being set up. percent of the market share. Statistics are as of 2009. 210 Financial Development and Inclusive Growth Financial Sector Development Agenda 211 53 As of 2010, only 25 of the 632 regulated plans were defined contribution plans. 54 A detailed description of Egypt’s primary and secondary markets for equity and fixed-income securities is contained in Chapter 5. This discussion of capital markets regulation should be read in conjunction with Chapter 5. 55 EFSA Decision 71 of 2009 approved 7 local credit rating agencies in addition to the three global rating agencies – Moody’s, Standard and Poors, and Fitch. 56 148 firms are licensed members of the EGX. However the industry is highly concentrated. The top 30 firms accounted for more than 80 percent of traded value in 2010. 57 For details see: Safavian, M. Fleisig, H., and Stienbuks, J. (2006), Unlocking Dead Capital: How Reforming Collateral Law Improves Access to Finance, Public Policy for Private Sector, World Bank, March 2006; and Fleisig, H. (1998), “Economic functions of Security in a Market Economy” (in: Morton J. and Andenas, M. (eds), Emerging Markets and Secured Transactions). 58 Wood, P. (1995), Comparative Law on Securities and Guarantees, p.5. 59 Country Finance: Egypt, Economist Intelligence Unit, December 2010, (“EIU- 2010”), P. 39. 60 International Finance Corporation, Doing Business 2013 – Egypt, (“Doing Business 2013”), p. 55. 61 OECD, Business Climate Development Strategy, Phase 1 Policy Assessment, Egypt Access to Finance, July 2010, (“OECD”), P. 53. 62 Doing Business 2013, p. 98. 63 OECD, p. 9. 64 Thorsten Beck, Tilburg University and CEPR Financing Egypt’s New Future: Opportunities and Challenges, 6. Financial Sector Development Agenda 2011, p. 32. 65 EIU - 2010, p. 34. A considerable body of research suggests that getting the financial system to work effectively is crucial to achieving these goals. This report has examined the Egyptian financial system, tracing its evolution through history, comparing it to that present in other, comparator countries, and identifying features of the Egyptian financial system that officials might consider examining more closely as they seek to implement reforms that promote economic growth, reduce poverty, and expand opportunities. As Egypt moves towards a new vision offering more equitable opportunities and active participation by citizens in their governance, it also faces challenges. Yet, the current environment also offers opportunities for improvement and reform, including creating a more inclusive financial system. It would be worthwhile that Egypt explores the different types of fiscal commitment mechanisms and policy options. Fiscal rules are useful mechanisms, and developing countries have used them with varying degrees of success. Brazil, Chile, and Colombia have used them with relative success, in spite of the differences in the legal frameworks. To pave the way for this medium term objective, the fiscal reform agenda of the immediate future must take great strides in the areas of transparency in the fiscal reporting and ensuring comprehensiveness of the budget. Without these two, no fiscal commitment mechanism will work, and any fiscal adjustment will be sub- optimal because the full spending and revenue envelopes are not known to the decision makers. It is also critical at this stage in Egypt to mitigate the risk of the reversal of reforms. The interim governments that were appointed post 212 Financial Development and Inclusive Growth Financial Sector Development Agenda 213 the 25th of January revolution were not in a position to make long-term pre-condition for financial deepening, to sustain a high frontier and push strategic decisions, and were often pressured towards unsustainable populist it further out. Second, institution building in the areas of contractual and policies. The hostility towards those previously benefitting from privilege and information framework is critical to push out the frontier. To benefit from corruption should not lead to a universal condemnation of market mechanisms a wider frontier, however a redefinition of the role of the government is and private sector led financial sector reforms. This could be achieved by necessary, beyond the substantial reforms of the past years. Similarly, the enhancing the policy dialogue and consultations with all stakeholders, lack of competition and regulatory constraints prevent the financial system including government officials, Parliamentarians, political forces, academia, from reaping the benefits offered by new technologies. Finally, we argue for private sector, civil society, and development partners. The following lines a new regulatory approach that gives more space to market-based financial will reiterate the nine pillars that lay the foundation of a comprehensive innovation, while at the same time fosters more market discipline. agenda for financial sector development in Egypt. It is important to stress that the further deepening and broadening of the financial system can only take place in the context of a stable, but open Deepening and Broadening the Financial System political environment. A stable political environment will also be critical in The concept of the financial depth frontier (Beck and de la Torre 2007) terms of attracting urgently needed foreign capital flows, both directly but builds on the two main barriers that financial institutions and markets face also through the banking system. in deepening and broadening: (i) transaction costs and the resulting scale economies of financial services at the level of the user, the institution, and Macro and Socio-Economic Stability the market and (ii) systemic and idiosyncratic risks. Fixed transaction costs A sound and effective financial system depends critically on the in financial service provision result in decreasing unit costs as the number macroeconomic environment in which it operates. Maintaining fiscal or size of transactions increases. These fixed costs exist at the level of the discipline and–partly affected by this, monetary and real, exchange rate transaction, client, institution, and even financial system. In addition to stability is critical for long-term finance and the Finance for Growth agenda. costs, the expansion in the supply of financial services, especially credit and Maintaining fiscal and therefore monetary discipline will be more difficult in insurance services is constrained by risks, particularly the risk of default. the coming months and years, as public pressure on fiscal policy will increase, The risks can be either contract specific or systemic. As systemic risk partly due to the democratization of the political process. However, it will be increases, it enlarges the set of borrowers and projects that find the cost of more than ever critical to reduce crowding out effects on the banking systems credit unaffordable and are thus priced out of the credit market. and in bond markets and thus give sufficient space for private sector lending. The financial depth frontier is determined by state variables that are It is important, however, to understand that a stable macro- either exogenous to the country–such as country size and state of technology– environment–a low and stable inflation rate, a sustainable fiscal position and exogenous to the financial sector policy makers–socio-political stability, stable exchange rate - is a necessary, though far from sufficient condition economic structure–or policy areas that are not subject to short-terms changes for further financial deepening and broadening. Macroeconomic stability including contractual and information frameworks, market development determines the location of the financial depth frontier; however, it does not etc. These state variables provide not only a floor for the costs of financial determine the location of the financial system with respect to the frontier. service provision but also the environment in which financial institutions Egypt had achieved a certain degree of macro- and socio-economic stability can manage their risks. Using the concept of state variables allows us to over the past decade or so, without having been able to reap the benefits in define the financial depth frontier as a rationed equilibrium, that is, the terms of a deeper and more inclusive financial system. maximum sustainable depth and breadth of a financial system. This frontier is different for savings and payment services, in which the transaction costs Improving the Institutional Environment are the decisive market friction, and credit and insurance services, in which The financial system ameliorates informational problems before the risk dimension is an additional important friction. However, the frontier investments are made; it affects corporate governance by reducing is also determined by demand-side constraints, including voluntary exclusion informational problems after investments are initiated; it facilitates or exclusion for religious reasons. risk diversification; and it eases the mobilization of savings by lowering While a broader set of data would be needed to locate the frontier in information and transactions costs. Building the institutional framework for the case of Egypt, the previous discussion has shown that Egypt’s financial financial institution and markets to function effectively is the quintessential system is far its frontier of possibilities, while there is also significant room market-developing policy area. Such reforms address deficiencies in the state for the frontier to move out. This section of the report will discuss areas of variables that keep the frontier too low. On the one hand, important reforms deepening and broadening the financial sector, which would be followed by have been implemented over the past years, which earned Egypt the title key sectoral specific recommendations. First, macroeconomic stability is a “Doing Business Reformer of the Year” in several occasions. Most notably, the 214 Financial Development and Inclusive Growth Financial Sector Development Agenda 215 establishment of I-Score, the privately-owned and managed credit bureau, option, also applied successfully in several Latin American countries, constitutes an enormous improvement in the informational framework as has been to move away from offering retail services through specialized already discussed above. Anecdotal evidence suggests that the introduction developmental financial institutions to a wholesale model, such as through of economic courts has been helpful. the SFD. In general terms, it is important that the government undertake a Nevertheless, further reforms, are urgently needed as basis for enabling holistic review of the sector and, for each institution and program, explore more long-term finance and expanding the universe of bankable entrepreneurs. and define a mandate, a set of different options, and a framework of funding Specifically, the lack of a centralized property register holds back the mortgage of subsidies. If the government considers subsidies in the financial sector market; currently, mortgages are registered with a local notary public, which necessary, then such programs should be made available for both private and does not allow for checking claims on a national basis. There is no legal and state-owned financial institutions to the same extent, to thus create a level institutional framework for movable collateral. Further, the insolvency regime playing field. is ineffective, focusing exclusively on liquidation rather than allowing for Redefining the relationship between market participants and restructuring of viable enterprises, which undermines its effective use. Many authorities. As important as addressing the governance issues in public- of these reform needs are discussed in other parts of this report. sector banks and leveling the playing field between public and private Reforms of the contractual and information frameworks will help financial institutions is to redefine the relationship between private market push the frontier out. They will enable the creation of new or deepening of participants and supervisory authorities. This would imply adjusting the existing market segments–such as mortgage finance, derivative markets regulatory framework for privately owned banks, with the goal of balancing etc.–and thus provide possibilities to deepen the market. As in the case of supervisory and market discipline, where the emphasis is currently macroeconomic stability, however, these measures are necessary but not completely on the former. Specifically, the regulatory approach is currently sufficient conditions for deepening and broadening the financial system. This one of guidance of market participants. Two examples include the rather rigid will require additional policies that we will discuss next. branch regulation policy and the lack of a bank resolution framework, which implies the impossibility to force the exit of weak banks. This regulatory Redefining the Role of Government and supervisory approach is best understood on the background of several The Financial Sector Reform Program launched in 2004 has decades of financial repressions with heavy-handed regulatory involvement. significantly contributed to a redefinition of government’s role in the financial The further rebalancing of supervisory and market discipline is thus as much system by substantially reducing the ownership share of government in an issue of attitude as it is an issue of specific regulations. Redefining the banking. It is important however, that this progress not be reversed under relationship between market participants and supervisory authorities has current political pressure in political transition process. It is important benefits both in terms of market-enabling and market-harnessing policies. It to understand that a private-sector led financial system is critical for its can help foster the necessary innovation, partly through more competition, positive impact on economic growth, notwithstanding an important role for and help increase financial stability by strengthening market discipline and government, a topic we will return to shortly. Such a private-sector led fostering more adequate risk decisions. financial system, however, has to function within a competitive environment While we advocate a reduced role of the government in retail provision and within a regulatory framework providing the right incentives for sound of financial services, there are other ways that the public sector can help risk decisions. move the financial system towards the frontier beyond macroeconomic Developing clear ownership policies. Given popular opposition, stability and institution building. One of these market-enabling policies is alternatives to the privatization of government-owned banks should be to provide risk mitigation tools, such as credit guarantees, which can help explored, including management contracts. Examples from Sub-Saharan overcome market frictions, including the lack of collateral by many SMEs and Africa, such as the National Microfinance Bank in Tanzania, have shown mitigate liquidity and maturity risks. As so often, the devil is in the detail that such an approach can be useful. Under a management contract, of pricing, funding, and institutional structure. The important assessment a private firm assumes the overall responsibility for the operation and criteria for credit guarantee schemes are additionality and sustainability. maintenance of a service delivery system and retains the freedom to make How many credit-worthy borrowers who previously did not have a loan could day-to-day management decisions. In the context of further restructuring of be included through an existing or potential scheme, this requires not only government-owned financial institutions, it is critical to come up with a clear an assessment of the additionality effect in itself, but also an assessment ownership policy that defines objectives and role of government authorities of the credit-worthiness of the additional borrowers. The other important in government-owned financial institutions. This ownership policy should criterion is financial sustainability. The design of the scheme can be critical be published and should not be subject to frequent change. An interesting for reaching these two goals. 216 Financial Development and Inclusive Growth Financial Sector Development Agenda 217 Fostering Competition and Innovation come from outside the financial system, such as from telecom companies Redefining government’s role is still on the more general policy level, providing mobile payment services. It is important for regulators to focus but is not an objective per se. Rather, defining the relative roles of public on the specific financial services offered or proposed, not the nature of the and private sectors ultimately has the goal of ensuring competitive and institution providing or aiming to provide the services. This view encourages sustainable financial markets. Competition is critical for setting incentives the unbundling of financial services across banks and nonbank actors. As for financial institutions to maximize the exploitation of the possibilities long as the risk of consumer abuse is adequately guarded against, different created by a conductive macroeconomic environment and technology and actors should be encouraged or at least not discouraged from providing thus push the financial system towards the frontier. However, this entails narrowly defined services. This could include deposit collection services by a sophisticated approach that has to balance the need for innovation and non-financial corporations, including supermarkets and others, working the need to reduce the risks of fragility. Competition has been shown to be with banks in the form of agency agreements, or payment services offered by critical for deepening and broadening the financial system, but can also telecom companies. have negative repercussions for stability if coupled with a weak regulatory Increasing availability of information. Competition can also be framework. In this context, it is important to understand that market fostered by broadening the use of financial infrastructure. For example, structure is not the same as competition; even concentrated banking systems it is important to encourage the use of credit information by microfinance can be highly competitive if there is a level playing field among several strong institutions, if necessary with a subsidy on the costs. Another important players, contestability achieved with the threat of entry, and competition policy tool to foster competition is through transparency, by, for example, from players outside of the sector. On the other hand, a dispersed banking starting with publishing more information about banks. The decision by CBE system of niche banks typically shows a low degree of competition. to begin disclosing and publicly disclosing on its website the consolidated Allowing new players to enter the sector. There is an implicit de banking sector financial statements and related indicators is a welcome first facto moratorium on new bank licenses as evidenced by the fact that since step. Other areas where more transparency and disclosure can help relates 2006 no new bank has obtained a license. Egypt seems to be lacking a clear to account-related fees and conditions for customers. policy concerning new bank entry, be it domestic or foreign players. The Strengthening the Regulatory Framework background for this seems to be the consolidation process of the past seven years, which led to the exit of several weak banks and emergence of overall We have discussed the role of competition to push the financial system larger–and better capitalized - banks. To ensure the necessary competitive towards the frontier and the necessary changes in the role of government pressure, opening the banking sector for new players is critical. In addition that this implies. In the following final sub-section, we focus more specifically to allowing new entry, there are other means to encourage competition on regulatory policies that can help push the financial system towards the between incumbent institutions and thus deepen and broaden the financial frontier, while at the same time preventing it from moving beyond the system. In terms of access to markets–and as noted in other parts of this frontier. Some of these policies will also have an impact on competition. book --the playing field across banks is not even, with only some banks being Designing a flexible framework. The Egyptian authorities have PDs for government securities, while others having only indirect access. introduced an exemption from reserve requirements for the amount that Using the franchise value and the network coverage of the Post Office for banks lend to SMEs. Rather than having exemptions or regulatory “subsidies” outreach purposes can increase significantly access to banking services, as for SME lending, it would be better to have a regulatory framework that the example of Brazil has shown. is flexible towards lending to different client groups. Regulations more Going beyond the banking sector. Fostering competition implies conducive to fostering SME lending would be to allow for more flexibility in looking beyond the banking system. As noted in several previous instances, terms of which asset classes can be used as collateral in loan provisioning the non-bank sector is underdeveloped. One segment that can complement rules. Similarly, relaxing the rule that all corporate borrowers (including the banking system as well as provide competition is the microfinance SMEs) have to have audited financial statements can help to expand the segment. Currently limited to the NGO model, new legislation foresees bankable share of enterprises. There are also areas where there is regulatory them taking corporate form and being supervised by EFSA. However, they overreach, such as the branch requirements that seem rather burdensome, would still be limited to credit services. In the medium-term, it might be including the requirement that banks need a certain capital to open a new advisable to allow sound microfinance institutions to start collecting deposits branch and have to submit a business plan. Similarly, a less restrictive –a move that would imply supervision by the CBE rather than EFSA. approach in terms of permitting new products can be conducive for the Alternatively, one could think of a separate regulatory form, such as micro- necessary financial innovation to deepen and broaden Egypt’s financial deposit taking institutions. Innovation for the financial system can also system to the benefit of its users. 218 Financial Development and Inclusive Growth Financial Sector Development Agenda 219 Introducing Shari‘a-compliant products. Another important intermediation and are offered limited financial products. On the supply area for regulatory reform in the coming years will be on Shari‘a-compliant side, banks are reluctant to lend to micro enterprises, especially young finance. As discussed above, there is most likely considerable latent demand and new ones, due to the perceived associated risk. Furthermore, banks for Islamic financial products. It is important that the regulatory authorities continue to lend based on collateral as opposed to cash-flow, narrowing keep an open mind concerning this growth area. In this context, it might the opportunities for these enterprises that often do not have sufficient be important to introduce the necessary infrastructure for Islamic products, collateral. Banks in Egypt effectively serve privileged large well established including a Shari‘a-compliant discount window. However, it might also require enterprises. Attempting at those hindering factors is key in capitalizing on careful risk-based supervisory monitoring. The regulatory framework of the impact of microfinance on the alleviation of poverty in specific and on Islamic banking needs further work to make it consistent with international the economy as a whole. practices, while maintaining the unique features of Islamic finance and not Enhancing rural finance. Development of the rural sector and compromising Shari‘a principles. the reduction of rural poverty, also remain constrained by lack of access to Focusing on accountability and market discipline. Regulatory finance. Responding to the development needs of rural areas requires a multi- policies that allow for more innovation and focus less on prohibition should pronged approach. Global literature has amply demonstrated that one of the be accompanied by a stronger focus on accountability and market discipline; key elements is the provision of quality financial services to the country’s this should include encouraging more banks to list on the stock exchange, and cultivated areas. Better access to financing of essential inputs will help in the to obtain credit rating from international credit rating agencies, as well as enhancement of crop productivity, which would then contribute to poverty establishing an incentive-compatible bank resolution framework that allows reduction and to economic growth. However, in Egypt, the agricultural sector for the failure of banks without disrupting the remaining financial system receives only one percent of total lending compared to 38 percent and 26 and the economy at large. Ongoing governance reforms for commercial banks, percent for industry and services respectively, while agriculture provides including the forthcoming Corporate Governance Code for the banking sector direct and indirect livelihood for approximately 55 percent of the population. and including governance criteria in the supervision process are welcome Poverty in Egypt is heavily concentrated in the rural agricultural sector and developments in this context. the gap between this sector and other economic sectors has been widening, while delivery of financial services to rural areas has declined. Boosting Unusual Access to Finance Promoting SMEs access to finance. An inclusive financial system can A Better Performing Banking Sector play a pivotal role in job creation, poverty reduction and overall sustainable It is important to keep the momentum and pace of reforms at the economic growth. Smaller enterprises are important contributors to total CBE, specifically regarding the publication of the Financial Stability Report, employment, job creation, and overall economic development. In Egypt, conducting the stress-testing exercises, close monitoring of banks’ portfolios according to empirical evidence, small and young enterprises are the main and NPLs, and applying Basel II framework to all Egyptian banks. A main creators of new job opportunities. Entrepreneurship and new business challenge for policymakers in Egypt is to design a framework that ensures formation is a linchpin to the process of innovation and creative destruction. functional independence of the CBE. This implies that better coordination Young enterprises are five times more likely to be ‘gazelles’ and are estimated between fiscal and monetary policy is needed to anchor expectations. This to be 3.5 times more likely to grow (measured by employment) than other independence is needed to ensure the CBE’s ability to influence inflation enterprises. Yet, Egypt has a very low business entry rate. Weak governance, expectations and maintain them within the inflation target range. To achieve privileged lending, lack of a level playing field, and unequal access to this, the policymaking framework must ensure that expectations of fiscal markets, contributed to limited economic opportunities and jobs, as well as events, which are exogenous to the CBE, are not incompatible with price an underdeveloped SME sector, hence, ensuring equal access to markets stability. Under political pressure, and faced with social unrest, authorities and restoring citizens’ confidence and are prerequisites for generating equal could be tempted to choose policies addressing short-term concerns, which opportunities and creating productive jobs. could undermine long-term private sector-led growth. Hence, a mechanism Boosting microfinance. Microfinance proved to be critical to that contains fiscal expectations within certain bounds is a necessary element expanding private sector development and addressing economic challenges of an economic policy framework. in Egypt. At the microeconomic level, access and use of appropriate Increasing the soundness of the banking sector. Also, as mentioned financial services improves household welfare and spurs household by Tapscott and Ticoll (2003), to increase the soundness of the banking enterprise activity, offering greater opportunity and choice to low-income sector (Conventional and Islamic), countries should consider the following households. Microenterprises suffer disproportionately from low financial strategies: (i) speeding up the electronic delivery systems in the financial 220 Financial Development and Inclusive Growth Financial Sector Development Agenda 221 sector and benchmark the systems to global standards; (ii) increasing the Egypt, or taking an interest in an already established regional reinsurer. flow of information across all the stake-holders in the financial sector; (iii) Furthermore, a program should be established to enable Misr Insurance upgrading the legal framework to meet the needs of the new economy; and (iv) and Misr Life to achieve benchmark staffing levels over the medium term strengthening the internal and external relevance of governance in the banking and to offer market level remuneration packages so as to be able to attract sector to stem out market failures and corruption, including e-corruption. This high quality professionals Policy makers should also consider putting public report showed that despite the contracting demand for credit, credit to the sector insurance staff group life arrangements onto same basis as other government provides an alternative use of funds to the banking sector that plans. Finally, it would be important to further modify the law to make it accounts for the major part in the decline of credit to the private sector. Hence, illegal for any salaried officer of an insurer, and his immediate family, to own fiscal adjustment will imply credit flowing back to the private sector. an insurance agency Limiting exposure to government risk. To expedite the transition, Regulatory and supervisory measures to develop NBFI services. the bank’s exposure to the government risk, especially of public and specialized With regards to the risk rating of insurers, authorities should institute more banks, could be limited to a specific level. For instance, in Brazil, the limit for objective risk matrixes including numerical measures such as IRIS ratios and credit operations of banks with sub national governments and state owned solvency ratios (using risk based capital measures). It is also recommended companies was set at 45 percent of equity. Currently in the US, law restricts for the law to require EFSA to apply corrective actions based on risk ratings the amount of exposure banks can have to a single counterparty to 25 percent and to enable EFSA to apply meaningful sanctions in accord with the of their regulatory capital. Recently the UAE central bank set new limits relevant IAIS Core Principles. With regards to, private pension funds, it is of 100 percent of the capital base for all lending by a bank to governments recommended that the Draft Private Pension Law is enacted. All proposed of the seven-member UAE federation and their non-commercial entities, recommendations should take place within twelve to twenty four months. and 25 percent to individual borrowers. In Mexico, a similar regulation was adopted, but was conditional on the banks capitalization: banks with capital Promoting Capital Markets ratios above 15 percent will have an exposure limit to single sub-sovereign A three-prong equity market development strategy is proposed. entities of 40 percent of their Tier 1 capital, while less capitalized banks at Expanding the functionality and capacity of the EGX is the first prong. the minimum regulatory level of 8 percent would have an exposure limit Building a robust institutional investor base to increase the supply of of 12 percent of Tier 1 capital. In Egypt, the sub-national entities are not investment capital and the demand for equity securities is the second major sources of risk, but lending to the national government and state- component of this strategy. The third prong focuses on growing the number owned enterprises should have some cost in terms of the capital adequacy of publicly listed companies on the EGX through complementary initiatives. regulation of banks. Expanding the capacity of the equity market. The EGX should be encouraged and authorized to expand its range of securities products and Developing NBFI Services range of permitted trading methods. The EGX does not have derivatives Policy recommendations to develop NBFI services. It would be products and it operates with a number of prudential rules that are intended advisable to develop a plan to establish a central database along the lines of to reduce trading volatility but also reduce market liquidity and efficiency. the Turkish TRAMER system so that claims provisions and premium rates These rules include limitations on intra-day trading, limitations on margin may be accurately determined. Policy makers should consider establishing trading in some stocks, a prohibition on short selling, and price limits and a surplus lines risks pool. Concerning pension policy, in order to achieve a trading halts. The statutory prohibition on brokers engaging in proprietary greater degree of social transfer progressivity, it is critical to create more trading, although likely ineffectual, also adversely affects market efficiency fiscal space, reduce the scope for directed investments and provide more and liquidity. These limitations are common in new, undeveloped markets. opportunity for the institutional investor sector. Furthermore, in order Reducing market volatility is also a common regulatory priority in new to enhance access, it is suggested that a strategy be developed to actively markets. However, these types of restrictions should be viewed as temporary support the development of the micro-insurance sector. This could involve and transitory. If a secondary market is going to develop into an effective an enhancement of Misr Life’s business model and the development of micro- vehicle for price discovery and investment opportunities, it must evolve and Takaful. To provide more fiscal space to enhance services to the rural poor, its rules must, over time, balance the risks of volatility with the benefits of incentives should be provided for employers and individuals to take out market liquidity. health insurance. It is recommended that policy makers do not establish Stimulating the EGX through sale of government shares. The a new state owned reinsurer but should instead consider supporting the EGX problems of limited free float and low liquidity and turnover could be development of properly capitalized privately owned regional reinsurers in ameliorated by an orderly, transparent and disciplined government sale of 222 Financial Development and Inclusive Growth Financial Sector Development Agenda 223 some portion of its substantial shares in companies that are publicly listed on would not only provide a stimulus to the Egyptian economy at a time when the EGX. This would provide a stimulus to the EGX. The resulting increase in it is most needed. It would also be an important signal to foreign investors the number of available shares of “blue chip” Egyptian companies would also that Egypt should continue to be viewed as one of the most attractive assist in the growth of an institutional investor sector in Egypt. In Egypt, the emerging market countries, as it was for the past decade. Future government government has historically played a pivotal role in economic growth. Given privatization efforts should be conducted through public offerings via the how engrained this role is in Egypt, it would be unrealistic to assume that it EGX. One of the benefits of a functioning, transparent secondary market, is could be abandoned entirely. However, the government must recognize that its use as a vehicle for a governmental “exit strategy”. Instead of engaging the benefits of its role in the economic development of specific companies will in a private, negotiated deal to privatize government ownership, which can likely decline over time as the companies grow and become well established. create the perception of corruption or cronyism, the government can sell its Using insurance companies and pension plans to build the interest via an equity offering on a stock exchange. The market will set the institutional investor base. The absence of a meaningful domestic fair price, and all investors can participate equally. institutional investor base has been a significant constraint on EGX An effective equity market must be deep, liquid and efficient. And it must development. Life insurance companies and pension funds are financial be fair. An effective regulatory program must encompass a wide array of duties. intermediaries with long investment horizons who can provide long-term The recommendations on NBFI regulation in this report should be viewed as an investments and professional market sophistication to an equity market. In integral component of a national equity market development strategy. Egypt, the appropriate regulatory agencies should review their prudential guidelines on asset allocation to ensure that insurance companies and pension Developing the Money Market plans allocate an appropriate portion of their assets to equities. This approach Liquid money markets may be supported or constrained by how would be highly beneficial to equity market development and it would be the CBE manages liquidity. This may involve several complex trade-offs, consistent with international best practices for the regulation of insurance particularly in situations where there is chronic excess liquidity (e.g. in companies and pension plans. In the same vein, the legal proposals to require presence of large capital inflows), or undeveloped institutional arrangements pension plans to retain professional investment managers and permit the on the government’s institutions cash flow management. These are medium- use of pooled investment vehicles, would also achieve both objectives–market term and complex reforms. However, there is also another set of operational development and effective regulation of these institutional investors. changes, such as a robust Repo market framework that can have a positive Promoting private equity and venture capital. Egypt should short-term impact on money markets. Two sets of reforms are proposed: (i) emphasize the importance of growing its private equity and venture capital develop a sterilization framework over the medium-term supportive of money (PE/VC) industry as an initial provider of investment capital and managerial and debt market development. This complex reform is generally implemented expertise to small promising companies. First stage companies may be too over time and requires strategic decisions at the highest level. It would also speculative for public investors and too small to be of interest to institutional require an in depth assessment of current monetary policy instruments and investors. The fixed costs of being a publicly listed company may be too great how they can evolve into the new framework with the participation of different and too burdensome for first stage companies. VC/PE can be more effective areas within CBE, including at least Monetary Policy, Market Operations sources of investment capital. In this model, the IPO and listing should be and the Payment System; and (ii) Develop a robust Repo market framework viewed as the goal for the second stage of growth, after the company has covering both T-bills and T-bonds in equivalent terms. This is a reform with become viable and has grown to a sufficient size. The companies that succeed high operational content. It can be developed in the short term but would and grow following private investment can go public through an IPO. The require a significant upgrade in the T-Bond settlement infrastructure. IPO provides the exit strategy for VC/PE. The investing public benefits from Government fixed income markets. Egypt had been making being able to invest in a larger company with a track record of performance substantial progress in the implementation of an agenda of reforms initiated and a clearer understanding of further investment potential. in the second half of 2008 to develop its government fixed income markets. Renewing commitment to public-private partnership As conditions stabilize, implementation should resume and cover all relevant development initiatives. Several important PPP projects have been building blocks for the development of government fixed income markets. suspended or postponed since 2011 due to government uncertainty over the Reforms in money markets, the investor base and clearing and settlement merits of the project, and possibly because of concerns over the terms of the infrastructure (as suggested in their respective sections in this report), project. These projects could be vital to stimulating the Egyptian economy. should be complemented by other recommendations related to primary and The government should carefully review the merits of the project and terms secondary markets. Reforms in primary and secondary markets would be of the project. Going forward on the most important and most attractive PPP leveraged by a careful review of the set of incentives and obligations of PDs 224 Financial Development and Inclusive Growth Financial Sector Development Agenda 225 to foster competition in auctions, support the strategy to reduce refinancing markets. It is recommended to reinforce growth of NBFIs and their role in risk (e.g. grant incentives for active participation in liability management disintermediation with an emphasis on mutual funds given their stronger transactions) and improve liquidity in secondary markets. potential for growth. Three complementary sets of actions are suggested Primary Markets. There is a need for the design and introduction of (i) continue planned reforms in the insurance and private pension an issuance calendar adapted to a post-revolution period. Authorities should sectors including changes in their investment regulations so as to reduce reassess and resume a benchmark building strategy taking into account dependency on bank deposits; (ii) modify regulations to reduce dependency limitations brought on by the revolution. They must also implement measures on banks to develop mutual funds (e.g. reduction of 5 percent of NAV in to mitigate refinancing risk. These measures are urgently needed to address funds, exclusivity of banks in funds distribution); (ii) reinforce oversight large concentrations of debt coming due especially in 2013 and may entail and regulations on the mutual fund industry (e.g. broader diversity of funds, liability management transactions (buybacks and switches), improvements clearer differentiation between funds and implementation of regulations in cash management and other types of funding transactions (via different preventing conflicts of interest). instruments or in distinct markets). A robust clearing and settlement infrastructure. A robust clearing Secondary Markets. Policymakers should consider eliminating the and settlement platform is essential for the development of the government PD “de facto” monopoly in the T-Bond secondary markets, as well as adopting and non-government fixed income markets. In that aspect, it is recommended an electronic trading platform with auto-match options. Another important a decision be made on the institutional set-up of the CSD platforms that measure is creating a securities lending facility provided by Ministry of would minimize market segmentation and broaden access to settlement Finance to PDs. In order to strengthen price dissemination and transparency services to non-bank intermediaries with the potential to become active in in secondary markets, they must implement quoting obligations by PDs. secondary market trading. The institutional set up could follow either of two models: Model 1: CBE is responsible for the settlement of T-Bills directly Non-government fixed income markets. The development of non- and for T-Bonds through a sub-custody account at MCDR (see diagram government fixed income markets cuts across reforms that affect different above) and Model 2: CBE becomes responsible for the settlement of both segments of the financial sector (e.g. government debt markets, insurance and T-Bills and T-Bonds, whereas MCDR remains in charge of the settlement of pension funds). In this section, only those aspects that have a direct impact equities and corporate bonds. Furthermore, substantial upgrades to existing on the fixed income market will be mentioned. Details can be found in the platforms should be implemented. This could be planned in short term and background chapters by market segment. As a first step, it is recommended medium term phase. Short-term upgrades would concern mainly government to establish the development of corporate bond markets as a priority in the securities including: eliminating the pre-deposit obligation for government access to finance agenda with a selection of actions that could play a catalytic T-Bonds; implementing a securities lending facility by Ministry of Finance; role. Given the scope of the areas of work involved, a steering committee including settlement facilities for both legs of repo transactions (registration formed by the relevant governmental agencies in consultation with market of both legs and automatic settlement of the second leg); harmonizing the participants could be established. Three core axes for the reform plan are settlement cycle of T-Bills and T-Bonds. Medium term upgrades would include suggested. These include: (i) continue the reforms initiated in the government the full automation of the CSD at CBE; the ability of MCDR to settle OTC debt market, as described above, so that it becomes a provider of reliable price fixed income trades; settlement of the cash leg of both government and non- references for non-government fixed income instruments and the creation of government securities in CBE money; enhancing risk management schemes an efficient infrastructure; (ii) upgrade primary market rules with the aim of to allow for short selling. introducing flexibility and making institutional investors the drivers of non- government fixed income markets; (iii) give priority to a very flexible issuance Developing the Leasing Industry framework for commercial paper aimed at institutional investors; (iv) develop There remain several constraints facing the leasing industry that a hybrid primary market model aimed at institutions adapting the exempt have inhibited its growth and its ability to achieve its full potential. Of public offering regime implemented in other EMEs; (v) move gradually from these inhibiting factors, perhaps the most crucial is the scarcity of long-term a merit based into a disclosure oriented primary market regime (e.g. remove funding. Moreover, the relatively limited development of capital markets the investment grade minimum requirement); (vi) explore options to facilitate does not support the issuance of bonds to provide long-term funding. In order access by smaller companies with lower credit ratings; (vii) develop third party for the leasing industry to access the amount of long term funding needed guarantee schemes for individual or collective issuance; and (viii) authorize to grow exponentially, the bond and asset-backed securities markets need issues below investment grade and develop a true private placement regime. to be further developed in order to extend the average maturity of leasing A diversified investor base. A more diversified investor base contracts and better serve potential and existing clients. would benefit both the government and the non-government fixed income 226 Financial Development and Inclusive Growth Financial Sector Development Agenda 227 Strengthening the judicial and legal system. A stronger judicial can be extremely advantageous to the industry. Due to the government’s system, which is able to enforce foreclosures and ensure the efficient and increased domestic borrowing to reduce the fiscal deficit and the associated effective repossession of assets in case of default, is key to developing a crowding out of the private sector, it will become increasingly difficult for supportive regulatory environment for leasing. There is a great deal of banks to extend loans, especially to start-ups and SMEs. These exceptional confusion in the tax and accounting treatment of leasing as well as a general circumstances provide an excellent opportunity for this vital and vibrant inconsistency with international standards. The existing fiscal legislation industry to play an important role and serve a sector, which is the backbone treats financial leasing as a type of rent, not a form of financing, and hence, of the Egyptian economy and a major source of employment. does not create a level playing field between leasing and other forms of credit. The most urgent outstanding reform issues are: (i) setting up a central The definition of leasing in the law must be adjusted to reflect a clearer, more database to collect MTPL exposure and claims run off data so as to be able precise definition that differentiates this type of financial transaction from to accurately determine outstanding claims provisions and to set adequate all others including property hire or rent to prevent abuses of tax benefits premium rates (it is likely that a surplus lines risk sharing mechanism will and double taxation. While the establishment and development of economic also be required); (ii) passage of the Private Pension Law so as to strengthen courts is a step in the right direction, greater capacity building of these courts EFSA’s ability to supervise this sector and to ensure that professional and the training of judges–especially in leasing concepts - is necessary for fund management capacity is in place; (ii) developing a set of rules so as greater overall effectiveness. In order to increase the industry’s client base, to enable the issuance of additional bancassurance licenses, this will also it would also be of great benefit for the law to be amended to allow for leasing need a stronger and more engaged supervisory regime; (iv) upgrading EFSA’s for non-commercial purposes. ability to risk rate insurers and private pension funds and take appropriate More effective registry procedures. The leasing industry in Egypt enforcement actions; and (v) developing a medium term plan to deal with is also in need of a sounder institutional environment to operate within, staff related cost structures in Misr Insurance and Misr Life.Other desirable particularly through the establishment and development of more effective reforms are listed in tables 15 and 16. registry procedures. The absence of a registry for leased assets increases the Key development opportunities. Micro insurance, Takaful and risk to the lessor and hinders the expansion of the market. The law in Egypt health insurance, are key development opportunities and policies should be currently imposes requirements to register individual leasing contracts supportive of these growth areas; however the new pension/ disability system instead of the asset themselves. This is not only a cumbersome procedure could be either beneficial to the insurance or contractual savings sectors or for the lessor, but it also inhibits the development of a secondary market for seriously threaten future growth, depending on the details of its operation. moveable assets. It is vitally important for the industry that I-Score move Further consideration should be given to the application of contribution and forward with the establishment of its moveable assets registry. benefit caps to create fiscal space and improve equity. Increasing the availability of data and broadening understanding of the sector. One of the reasons the industry is not Developing Egypt’s Mortgage Market achieving its true potential is the lack of understanding of the sector and the The following recommendations represent key strategic areas, which limited information and data available on it. There is a lack of experience, could serve to support a more efficient, robust, and dynamic mortgage market, skills and understanding of the sector by current practitioners and potential better equipped to deliver the necessary housing investment Egypt requires. lessors as well as a general lack of awareness on the part of government Regulation of developer installment loans. Developer installment officials including agencies responsible for asset registration, courts, and loans should be fully regulated as consumer credit. Although no depositors the tax authority. Both EFSA and the Egyptian Leasing Association have are involved they represent a significant systemic risk and the collapse of a an important role to play in creating both a greater understanding as well developer could have disastrous repercussions on the wider sector as well as as greater visibility for the industry. While the quarterly reports issued by individuals directly. EFSA are helpful and a positive step forward, the data available remains to be Commission comprehensive review of developer financing. limited with only a few specific indicators being tracked on a regular basis and The current system of financing is neither sustainable nor best practice. A on an aggregate and cumulative level. Producing reports and disseminating comprehensive review of the way developers finance themselves should be information on the sector should be one of the Egyptian Leasing Associations conducted with the aim of creating a safer and more sustainable system. main objectives. Such a review should consider the following issues: (i) security of down Taking advantage of current circumstances. Although the payment for pre-sales- consideration should be given to establishing an industry has not grown as much as it has the potential to, especially in the escrow system which would protect buyers who have made a down payment past year, the circumstances surrounding the transition period in Egypt on a property depositors and (ii) developer financing - CBE should lift some 228 Financial Development and Inclusive Growth Financial Sector Development Agenda 229 of the uncertainty faced by banks in this area by issuing a more definitive Affordable Mortgage Finance Project together with the NHP will be the main statement of its policies, setting clear limits and guidance on permissible drivers of the mortgage market. By generating mortgage loans, lenders will lending by banks to developers. be enabled to invest more in their systems and reduce the spreads charged Alternatives to the escrow scheme. An alternative to the escrow on each loan. scheme could be a fully funded guarantee mechanism that is self-funded Develop Islamic housing finance. Islamic housing finance needs by the developers. This would require developers to pay premiums into an to be developed more fully both as a product serving the needs of customers independent fund that would provide purchasers with a guarantee of: (i) the within Egypt, but also as an economic opportunity to be part of a growing completion date of the purchased unit and (ii) the completion of the unit in sector in the region. Developing compliant Islamic Finance Products with the case of the bankruptcy of the developer. The main advantage of such a more generally applied principles on the prohibition of Riba (interest) would scheme is that it would become self-regulating. The guarantee fund would also potentially open up Egypt’s market more fully to capital market investors have a natural incentive to upheld and improve governance standards in who may be interested in buying such things as Sukuk bonds. the industry. It would be able to set standards for financial disclosure and reporting. It would also be able to bar some developers from the scheme Islamic Finance who do not meet certain standards either initially or on an ongoing basis. Developing a legal framework. Special laws for the introduction and Participation and compliance with the requirements of the scheme would be practice of Islamic Banking must be put in place. Such laws would facilitate an indication of credibility, thus increasing consumer confidence with respect the operation of Islamic banking side by side with CB. This set of laws will to participating developers who would in turn strive to obtain and maintain be concerned with the establishment, functioning and supervision of Islamic such credibility. banking in the country. The legal framework of Islamic banking must include, Regulatory measures to better monitor maturity mismatch among other things, the following: (i) higher risk-weighted capital asset risks. This will curb the strong reliance on the deposit base for long term requirements because of the incentives for Islamic financial institutions’ to lending. This need not be a drastic regulatory change but should be one, engage in risky activities and the absence of an incentive to use collateral; (ii) which at least limits the ongoing term transformation phenomenon. This stricter information disclosure requirements and close monitoring are also would reduce systemic risks in the market and encourage banks to fund important since deposits are not protected and depositors tend to allocate themselves using longer-term liabilities, which is not the case currently. funds across banks according to their risk preference; (iii) rules to ensure that Islamic financial institutions have adequate capabilities for project Additional resources for EFSA for mortgage regulation evaluation, appraisal, selection, auditing and monitoring, because Islamic and market supervision. EFSA should recruit additional experienced financial institutions face a stronger investment risk since direct investment supervision staff able to work on mortgage regulation. The transition (projects) are the main source of return for depositors and minimal use of from MFA to EFSA and then the subsequent changes that have occurred collateral is required. in management at EFSA has left EFSA without the necessary experience and personnel to deliver the requisite level of supervisory oversight for the Promoting corporate governance. The corporate governance mortgage market. There is a need to strengthen the qualifications, experience framework should protect shareholders’ rights. These include property rights, and number of mortgage supervisors. the right of representation, the separation of ownership and control, etc. The corporate governance framework should also ensure the equitable treatment Improved property registration mechanism. This is a major of all shareholders, including minority and foreign shareholders, as well obstacle, which at current rates of property registration will take another as recognize the rights of other stakeholders, whether covered by explicit decade to overcome. In this regard: (i) more effort should be made to or implicit contracts. It should ensure that timely and accurate disclosure encourage people to register their properties; and (ii) a lower level of accuracy is made on all material matters regarding the corporation, including the should be required for the mapping of title documents to remove bottlenecks financial situation, performance, ownership, and governance of the bank in the system. A move to ‘general boundary’ principles could yield efficiency and ensure the strategic guidance of the bank, the effective monitoring of improvements and a much more rapid rollout of the systematic registration management by the board, and the board’s accountability to the bank and to program. As long as effective dispute resolution mechanisms are included, shareholders. this should not be an insurmountable obstacle. Human capital formation. Because the adequate supply of qualified Expand and progress the Affordable Housing Program. The staff is vital for the continuing expansion of the Islamic banking industry and Affordable Housing Program affords major social benefits, as well as economic for proper risk management, it is critical to increase the supply of Islamic benefits through job creation. It is likely that over the coming few years, the scholars. Furthermore, it is extremely important to have the people with the 230 Financial Development and Inclusive Growth Financial Sector Development Agenda 231 right kind of skills and commitment to run Islamic banking, since managers of borrowing. Despite significant progress in recent years, concerns remain of Islamic banking are not well trained in the use of Islamic modes of finance. about institutional limits to the effectiveness of good corporate governance The employees and management of Islamic Banking also need to be trained at the state-owned banks. The fragmentation of the ownership function and in modern techniques of financial management, especially risk management, the continued dominance of management at these banks need to be further as well as information technology. addressed. Generally, there is still significant room for improvements in the Improving risk management. Improving risk management is very amount, quality, and frequency of public disclosure of financial information important as Islamic products are becoming more complex and sophisticated by banks. Generally, in Egypt there is a need to further develop the capacity with financial innovation. Given the specific nature of risk, Islamic Banking to assess market and operational risks, which will gain significance with the need a specific risk management approach. Reserve requirements in this case full implementation of Basel II. Doubts regarding the capacity to perform should be relatively higher to cater to huge default risk as well as to prevent examinations of banking groups on a solo and consolidated basis also need to depositors’ losses in case of poor performance and rapid capital outflow. be addressed, specifically by strengthening and formalizing the exchange of In addition to that, engaging some of bank’s capital into its investment information between the CBE and EFSA. operations and not only depositors’ funds, would limit the risk of moral The stress-testing of banks will have to consider broader scenarios hazard. In fact, Islamic banking tend to be more conservative than their than downgrade of borrowers’ credit risk, to include interest rate and conventional counterparts, possibly leading to lower profits. Also, because of liquidity risks, especially as exposures broaden and Basel II comes into the PLS principle and the implied lack of protection for depositors, information effect. The minimum 5 percent provisioning requirement for “watch disclosure requirements should be particularly strict in Islamic finance. The loans” should not be treated as a “general” provisioning, but as a “specific” government, along with other stakeholders, can work with domestic and provisioning, impacting on the CAR. The Macro-Prudential Unit may want international standards setting institutions to build and strengthen the to broaden, in its analysis, the scope of potential structural imbalances and financial infrastructure. A better understanding of the risk management and shocks that can affect financial stability. Also, the CBE ought to disclose governance issues of Islamic financial institutions will help governments in regularly the NPLs ratio of banks (i.e. NPLs over total loans). Finally, there performing enhanced risk monitoring, and timely management of financial is a need to continue assessing the implications of both Basel II and Basel sector risk. As in conventional finance, there is a need for an integrated crisis III for capital adequacy of each individual bank, and at the aggregate. management framework in Islamic finance to ensure that any emerging crisis Facilitating SME financing. There is strong evidence that in the Islamic financial system will be adequately managed. Such a framework the development of SME financing has been hampered by the lack of involves having the mechanism and vehicles to address short-term liquidity comprehensive banking regulations specifically tailored to such lending. problems, removing troubled assets from the balance sheets of financial overarching factors must be examined: first, the broad regulatory institutions and resolving solvency issues in Islamic financial institutions. infrastructure must be conducive to SME lending. This calls for minimum accounting standards manageable for SMEs, credit bureaus specializing Enhancing the Integrity of the Financial Sector in SME assessment, efficient legal enforcement of creditor and borrower Important steps for more effective banking supervision. With rights in the case of transactions with SMEs, and specialized SME respect to reliable financial reporting and auditing, there is a need to include credit rating agencies; and second, prudential regulations cannot, even in the banks’ quarterly reporting requirements information on the structure unintentionally, be biased against smaller enterprises. This calls for the and concentration of the bank’s shareholders, and on the loan concentrations banks to be allowed to take on exposures to SMEs based on a much broader reflecting the largest borrowers, given the relevance of this information to the choice of possible collaterals. As already mentioned, this would require a incentives for enhancing access to finance. Furthermore, with the increased new legal framework for movable collateral, supported by a centralized significance of brokerage, mortgage finance, and financial leasing subsidiaries registry for all types of collateral. and affiliates, it is becoming increasingly important to require all banks to Incentivizing banks to take on higher risk/reward lending. move to quarterly reporting of their consolidated operations as well. Banks must be provided an appropriate incentive structure that encourages There should be a requirement to have separate Risk Management and them to move into higher reward/risk lending opportunities. This can only be Audit committees. Greater conformity between CBE and EGX governance achieved through greater competition, based on market-oriented corporate and disclosure requirements, through further strengthening of CBE governance. Further commercialization and the reduced dominance of state- requirements, should encourage banks to list. In addition, the CBE should owned banks, will likely be a key factor in this regard, which would also develop incentives that encourage banks to seek an international credit rating, be facilitated by further privatization. Furthermore, credit guarantees/ for instance by making it a condition for banks to undertake certain types insurance should play a more important role in mitigating the credit risk 232 Financial Development and Inclusive Growth Financial Sector Development Agenda 233 assumed by banks when they take exposures, especially longer term, to more Development of the equity market and private fixed-income market risky borrowers such as SMEs. In this context, the experience elsewhere with requires the development of a robust institutional investor sector. Strong private sector-led Financial Guarantor Funds should be studied to see whether regulatory oversight of the institutional investor sector must accompany this they could be replicated in Egypt. Local chambers of commerce/ business and effort. In this regard, EFSA should work closely with the CBE to develop a professional associations could be especially well equipped to create such an mandatory uniform code of conduct for insurance company and mutual fund entity. Finally, specific regulations governing the securitization of SME loan sales practices and business conduct. In the same vein, EFSA should use its portfolios should be issued, with a view to enhancing the amount of financial existing regulatory authority to mandate improvements in public disclosure resources going to the sector. requirements for private benefit plans and mutual funds. Investors should Building an effective NBFI regulatory program. Completing the have full and prompt access to critical information on investing performance, consolidation of regulatory programs within EFSA should be viewed as an fees and expenses, and account value. Minimum plan benefit information is essential core requirement. While the events of January 2011 and June also essential. 2013, the uncertainties of the transitional government postponed many Opportunities exist for EFSA to improve its application of existing planned initiatives, resuming the effort to integrate the separate regulatory authority to important regulatory concerns. For example, EFSA should ensure functions should be a first-order priority. Strong executive leadership, clear that licensed intermediaries are adhering to restrictions on client purchases of support from the national government, and a significant increase in trained illiquid stocks with borrowed funds. EFSA should also complete its transition to professional and technical staff are required for success. Building an effective a risk-based examinations program and should take steps to promote the use of NBFI regulatory program will also require providing EFSA with additional internal risk-based rating systems at insurance companies. Building a strong and legal authority in several areas. In the event of a financial failure by a licensed effective NBFI regulatory structure presents a significant array of challenges. intermediary or other supervised entity, EFSA should be empowered to take While these challenges may be difficult, they are achievable. A foundation has prompt corrective action when needed to protect the public and to prevent been built in the past decade. Success in the next decade should be the goal. systemic financial crises. EFSA should also have the authority to revoke the licenses of registered entities that are no longer able to meet regulatory Implementing Appropriate Legal Reforms standards or that become dormant. EFSA should also be authorized to It is critical to understanding the existing legal environment and regulate all private pensions and benefit programs. A comprehensive legal evaluating efforts of legal reform that have taken place over the past decade. reform package should also define the legal status of the EGX and provide The Egyptian Revolution has resulted in many positive outcomes, one of which MCDR with the legal authority and responsibilities of a CCP for securities is the desire and power to change and reform institutions that have proved clearance and settlement processing. ineffective or represented an obstacle for efficiency. This positive outcome is The EFSA enforcement program has grown in recent years. To promote yet to be applied in the legal and regulatory arenas and it is yet to be seen continued growth, Law 10 of 2009 should be amended to provide EFSA how the holders of power will apply it to address historic inefficiencies and with comprehensive administrative enforcement authority. The Egyptian impediments. legal system does not recognize the concept of a civil enforcement action. Assessing the legal environment. Reforms in post revolution As such, EFSA enforcement proceedings must begin as criminal actions and Egypt should commence by a full study and review of the shortcomings of then be settled for money penalties. While some misconduct may warrant the existing legal and regulatory system and to assess in a neutral and fair criminal sanctions, most EFSA violations are better addressed through a manner the legal reforms that have taken place over the past decade with an civil sanction, involving a fine, possibly a suspension, and an agreement to objective of understanding what went wrong and why and also to continue remediate conduct. The process of charging criminal misconduct and then and reinforce successful reforms. Understanding the shortcomings of the settling for civil remedies may create a public perception of impropriety when status quo including pre-revolution reforms is key to approaching reform. prominent persons or companies are charged criminally and then punished The prevailing legal framework in Egypt constrains the cost and terms of only with a fine. Instead of undertaking fundamental changes in the Egyptian finance. Some laws are poorly written, especially those regarding secured legal system, EFSA should be empowered to act through an administrative transactions, bankruptcy, and settlement of disputes. Moreover, the court process. Such a process would have to be designed to provide defendants with system, though well reputed for its impartiality and independence, suffers full procedural due process protections, including a hearing on the record from several drawbacks that keep it from helping expedite debt collection before an independent adjudicator. The powers available for administrative and resolve other financial disputes. enforcement proceedings should be sufficiently broad to encompass violations There is a difficulty in discussing specific reform concepts absent under all of the laws administered by EFSA. the well-articulated and comprehensive policy objectives made by the new 234 Financial Development and Inclusive Growth Financial Sector Development Agenda 235 Egyptian government. Yet it is important for policy makers to appreciate for debt collection and resolution of other financial disputes. Bold reform that fundamental changes are needed. International experience offers several ideas need to be considered, which include: (i) Access to justice and with it the models and policy choices for consideration by Egyptian policy makers. Policy cost of litigation and the financial impact of losing a case; (ii) Appointment of makers should aim for a root and branch reform that would result in a law judges from the bench; and (iii) Reforming the appeal process. No change can that is responsive for the needs of Egypt and can be adequately enforced by take place absent a root and branch reform, which Egypt not only needs but the existing regulatory institutions. is capable of doing it in the coming few years. Enforcing laws on collateral. Laws on collateral are poorly enforced. The revolution, and its associated unforeseen risks, adversely affected the Property-rights registration and titling issues make it difficult for firms, performance of the financial sector and interrupted the reform program. The especially SMEs, to use land assets as collateral. Even when collateral is prolonged political transition has contributed to the delay and ambiguity about registered, there is no information on its value. This inadequate legal and policies and directions. Although this period has presented many challenges, it has judicial system has resulted in uncertainty and high cost, making banks also created many opportunities for reform. A core objective of Egypt’s economic reluctant to lend or opt to over collateralize their lending. planning going forward must be to support the establishment of a well-functioning Reforming the law on secured transactions. Shortcomings in financial sector. Prospects for reform are widespread and encompass many aspects rules for secured transactions have hindered access to finance. Egyptian including deepening and broadening the financial system through an improved law recognizes three major forms of security, mortgage, pledge, and macroeconomic environment; fostering competition and innovation; improving the business charge, all of which are governed by rules that have shown various institutional and regulatory framework; enhancing the soundness of the banking shortcomings in actual practice. These shortcomings have negatively affected sector; reducing exposure to government risk; developing NBFI services, capital the lending environment. The lack of non-possessory charges over moveable and equity markets, the leasing industry, and the mortgage market. Moreover, property deprives both lenders and borrowers of important collateral. it is important to ensure that the demands of the people are met with regards to Egyptian law can benefit from reforms that aim at changing the conceptual the provision of Islamic Shari‘a-compliant financial products. It is imperative that structure of the law. The Model Law on Secured Transactions represents policymakers not be diverted from the objective of sustainable economic growth by the most comprehensive work in the field of reforming the law on secured giving into to populist demand and resorting to short-term remedies. transactions in emerging economies. It presents solutions to issues relating to the creation of a security, the forms thereof and enforcement procedures that Concluding Remarks ensure efficiency of the system and is consistent with Civil Law traditions. A well-functioning financial system fosters competition by allowing Amending the bankruptcy law. The bankruptcy rules are embodied not only households but also promising firms to enter the market. A poorly in the New Commercial Code of 1999 under Articles 550–772. These rules functioning financial system can become an impediment to entrepreneurship provide few conceptual changes to the Code for 1883, which it replaced. They and growth. Successful financial policy reforms are those that intensify adhere to historical perceptions of the bankrupt betraying the trust vested competition in the financial system, enhance the quality of financial services by the creditors, and focus on personal bankruptcy as opposed to corporate provided to the non-financial sectors, lower entry barriers facing non-financial bankruptcy. A review of the rules—more than 200 Articles—shows that the firms, and increase the rate of new firm entry and old firm exit. Thus, a better process is multi-layered, complex, and time-consuming. It is important that functioning financial system reduces the degree to which accumulated wealth Egyptian policy makers appreciate the role and function of bankruptcy law shapes credit allocation and increases the degree to which the likelihood of and to shape the law in light of chosen objectives that include: (i) providing future economic success determines the flow of credit. an efficient process to help expedite settlement of bankruptcy cases, in an impartial, fair and within a reasonable time; (ii) providing the necessary Following the January 2011 and June 2013 revolutions, Egypt had mechanisms to distinguish between viable and unviable firms and assisting been confronted with many challenges but also major momentum for change viable firms in overcoming any temporary financial difficulties; (iii) assuring and reform. Besides overcoming the political challenges, Egyptian officials participants in the market that the law will interfere to protect their legitimate are working on creating a policy and institutional environment to foster expectations and interests; (iv) taking into account the social and economic sustainable and inclusive economic development, and aiming at uplifting implications of bankruptcy, this includes among other things, the interest of Egyptian people standard of living, and expanding the overall economic employees; and (v) dealing with insolvent entities at an early stage. horizons of the country. This is exerted in determination of meeting the Egyptian citizens’ aspiration for a better life, and equal opportunity in a fair Reforming the Court System. 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