Thursday 23, August 2018 by Banker Middle East

Investor realities

 

Ted Stephenson, CFA, Executive Director of CFA Society Emirates, provides an insight into corporate governance-related challenges and opportunities facing banks, financial institutions and the end investor in the GCC.

A Basel Committee on Banking Supervision report published in 2015 entitled Corporate Governance Principles for Banks, stated that “effective corporate governance is critical to the proper functioning of the banking sector and the economy. Banks perform a crucial role in the economy by intermediating funds from savers and depositors to activities that support enterprise and help drive economic growth. Governance weaknesses at banks that play a significant role in the financial system can result in the transmission of problems across the banking sector and the economy.”

Regulators intervened substantially after the global financial crisis in 2008 to improve corporate governance by introducing various laws and regulations. An Institute of International Finance (IIF) and Hawakamah report states that: “The willingness of banks to adopt better corporate governance practises to comply with regulations shows that companies can change practises if required to do so by regulators.”

A key element in drawing foreign institutional investment to the region is confidence. Confidence can be gained by building strong governance systems and an internationally accepted regulatory environment, transparent practises and accounting regimes.

Just as stock markets in the region migrate from ‘frontier’ to ‘emerging’ to ‘developed’, regulations continue to transition with regard to corporate governance frameworks. The Capital Market Authority in Saudi Arabia issued its resolution in 2017 approving new Corporate Governance Regulations. It states: “These provisions emphasise the principle of active participation in decision making within the Board of Directors as they deal with the issues of conflicts of interest between board members and the company, and adopt honesty, truthfulness and care as a foundation and methodology for these boards.”

In June 2017, MSCI added Saudi stocks to a watch-list for future inclusion in its MSCI’s Emerging Market Index and that has attracted capital into the market. As of 6 June, the Tadawul all share index is up 19.3 per cent in the last 6 months versus the S&P 500 return of 4.55 per cent. The UAE and Qatar were reclassified from Frontier to Emerging in 2014.

A case can be made that companies should proactively embrace good governance practises. In an Environment, Social, and Governance (ESG) presentation by Principles for Responsible Investment (PRI) and CFA Institute, research showed that: “…the correlation between ESG rating and risk-adjusted return turned significantly positive in the recent years and this positive correlation strengthens further by excluding the lowest ESG stocks.

Stocks with worst ESG exposures have total and stock-specific volatility that is up to 10-15 per cent higher, and betas up to three per cent higher, than stocks with the best ESG exposures.” 78 per cent of asset managers surveyed in the research report indicate that ESG analysis is integrated into equity analysis and that 59 per cent responded that Governance issues affect share prices always or often.

As actively managed equity investment capital continues to flow into the region, banks should pass through any type of exclusionary (negative) screening. Inclusionary (positive) screening and best-in-class screening which actively includes companies that meet an ESG standard may reduce the investable bank universe.

Regulators across the region are actively trying to foster a culture of innovation by introducing regulatory sandboxes and laboratories. These initiatives and others in the region are designed to promote the development of a knowledge-based economy in what is commonly referred to as the ‘post-oil’ era.

A challenge for banks in the GCC is the commitment to continue to improve corporate governance in the face of disruptive financial technologies and the need to balance the ostensibly contradictory demands of innovation and risk management. Innovative data and financial management systems introduce the potential for hacking, identity theft and misrepresentation. Systems integrity is an important element of corporate governance that should not be minimised.

The strong correlation between the price of oil, GDP growth, loan growth, bank profitability and credit ratings introduce a significant challenge for the GCC banks. Average GCC loan growth has dropped from a high of 11 per cent in 2012 to an estimated 3 per cent in 2017 and GDP growth has decreased from about six per cent to below two per cent.

In a S&P Global Ratings presentation to CFA Society Emirates in May 2018 entitled “Bank Rating Framework and A Brief Look into GCC Banks – 2018”, the outlook is that “the story is not the same for all GCC countries. S&P believe that GCC banks’ financial profiles will start stabilising from the second half of 2018, absent any materialisation of geopolitical risk. The three key risks that we foresee for GCC banks, in addition to geopolitical risks, are muted loan growth, a higher cost of risk, and lower profitability.”

Declining loan growth affects banking profitability and that has been reflected in bank credit ratings as presented by S&P Global Ratings. In 2015, there were 19 banks in the GCC rated from AA- to A-. As of April 2018, there are seven. Most of the movement has been to BBB+ category in which there were five banks in 2015 and now there are 13.

When comparing stock market indexes globally, in the GCC, the banking and financial sector is more heavily weighted by market capitalisation than in other countries or regions. The MSCI GCC Countries Index is about 49 per cent weighted in financials. By way of comparison, financials are weighted at 14 per cent of the S&P 500 index and 24 per cent in the MSCI Emerging Markets index where information technology is the largest sector by market cap in both indices.

The heavy weighting in banks and financials in the GCC has impacted index performance and unsurprisingly, returns in the GCC have lagged behind developed markets in both the five year and ten-year time frames.

Relative performance weakness due to macroeconomic factors strengthens the argument for the imperative of good governance.

In summary, corporate governance is a multi-faceted issue that is influenced and determined by a variety of complementary factors and forces.

Fundamentally good governance is dependent upon the integrity, accuracy and transparency of the processes and systems that ensure that the behaviour of the enterprise is well aligned with the interests of the stakeholders, including investors.

Progress towards and consistent achievement of “duty of care”—the goal of corporate governance—is strongly determined by government regulation, the presence of an active, vigilant and independent Board of Directors, the activities and pronouncements of the major credit rating agencies and finally, the integrity and transparency of the information systems which serve the stakeholders.

Each of these important components should be understood and intelligently integrated within a framework that continuously evolves to faithfully serve the stakeholders to whom the enterprise is ultimately accountable.

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