incentive-based regulations and bank restructuring in egypt

8/13/2019 Incentive-Based Regulations and Bank Restructuring in Egypt

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Incentive-Based Regulations and Bank Restructuring in Egypt

Alaa El-Shazly

Cairo University

E-Mail: [email protected]

Summary

The Egyptian authorities undertoo !a"or #aning refor!s in the $%%&s to'ards a !ore li#eral syste!. Thisincluded the strengthening of #an supervision and regulations on the #asis of internationally acceptedstandards to deal 'ith the riss inherent in the ne' policy environ!ent. To ensure the sta#ility of the #aninindustry( the regulatory policy should include ele!ents of private !aret discipline along 'ith strongenforce!ent !echanis!s of prudential #an regulation. The safety nets should #e #ased on rules designed t

align the private incentives of !aret players 'ith the social goal of financial sta#ility. )ncentives forprudence and safe #aning practices can protect !aret sta#ility and increase the #ans* franchise values

+E, Codes: ( E/( 01

1. Introduction

)n recent decades( !any countries have e2perienced #aning pro#le!s re3uiring !a"or refor!s of their#aning syste!s. The pro#le!s are largely due to do!estic causes( such as 'ea #aning supervision and

inade3uate capital. Also( #aning refor! !ay #e needed to !odernize the financial services industry( as inthe case of transition countries !oving fro! a pu#lic-sector-led to a !aret econo!y. E2ternal factors( suchas deteriorating ter!s of trade( can cause currency crises and 'orsen #aning pro#le!s.

The ti!ing of refor!s is i!portant in deter!ining the difficulty and cost of i!ple!entation. )n ti!es of#aning distress( depositors and o'ners of #an capital all lose confidence and see si!ultaneously tosalvage their resources #y 'ithdra'ing the!. This leads to #aning panic and the authorities have no option#ut to restore sta#ility 'ith policy re!edies that are !ore difficult and costly under a #aning crisis.overn!ents can do #etter( ho'ever( #y anticipating the need for refor!s and carrying the! out in ti!es ofrelative financial cal!.

Countries resolve their #aning pro#le!s #y adopting strategies( policies( and tools for refor! and successfurestructuring. 4an restructuring ai!s to i!prove #an perfor!ance5 that is( restore solvency andprofita#ility( i!prove the #aning syste! capacity to provide financial inter!ediation #et'een depositorsand #orro'ers( and restore pu#lic confidence. This re3uires a co!prehensive approach fro! policy!aers inaddressing #aning pro#le!s.

More precisely( #an restructuring can #e classified into three #road categories( na!ely( financial(operational and regulatory. Each of these categories has its o'n policy !easures 'hose synchronizedapplication can #ring a#out a !ore efficient 'oring of the #aning syste!. 6inancial restructuring atte!ptsto restore solvency #y i!proving #ans* #alance sheets or net 'orth7e.g.( #y raising additional capital or #yraising the recovery value of pro#le! loans and collateral. 8perational restructuring affects profita#ility 'it


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such !easures as i!proved !anage!ent and accounting syste!s( and #etter assess!ent of asset ris. 6inallenhancing supervision and prudential regulation as 'ell as esta#lishing safety nets( such as deposit insurancraise pu#lic confidence and add to the #aning syste!*s capacity for financial inter!ediation.9$

6ocusing on #an regulation( the safety nets should #e #ased on rules designed to align the private incentiveof !aret players 'ith the social goal of financial sta#ility. )ncentives for prudence and safe #aningpractices can protect !aret sta#ility and increase the #ans* franchise values 9i.e.( the capitalized value ofe2pected future profits. Thus govern!ents should introduce ele!ents of private !aret discipline as a !a"o

co!ponent of the regulatory regi!e along 'ith good rules and strong enforce!ent !echanis!s.

Si!ilar to !any e!erging !aret econo!ies( Egypt undertoo #aning sector refor!s in the $%%&s to'ardsa !ore li#eral syste!. The ne' policy environ!ent necessitated refining the !ethods used in !onitoringriss 'ith e!phasis on prudential #an regulation. The present paper sheds light on #an regulatory policy iEgypt and the incentive sche!es to foster healthy co!petition and ensure financial sta#ility.

The paper is organized as follo's. Section gives an e2position of structure and co!petition in the Egyptian#aning syste!. Section 1 focuses on prudential regulation and #an supervision and highlights i!pedi!ento stronger enforce!ent !echanis!s. Section ; discusses different sche!es for !onitoring #an #ehaviorunder infor!ational asy!!etries and the design of incentive-co!pati#le safety nets. Section < providesecono!etric evidence on #an heterogeneity and !aret discipline. Section / concludes.

2. The Egyptian Banking System: Structure and ompetition

The Egyptian #aning sector e2panded !aredly in the !id-$%=&s spurred #y the country*s so-called opendoor policy. This policy ai!ed at out'ard-looing gro'th 'ith an active role for the private sector topro!ote econo!ic perfor!ance. To serve the ne' policy( a #aning la' 'as enacted in $%=< 9,a'$&>$%=


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size( accounting for nearly


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govern!ents( 'hich often #ear a significant part of the costs of the #ailout. rudential regulation is !eant protect the #aning syste! fro! these pro#le!s #y inducing #ans to invest prudently. 8ne for! prudential regulation is capital re3uire!ents( typically using the 4an of )nternational Settle!ents 94)standards of the 4asle Accord. Capital re3uire!ents force #ans to have !ore of their o'n capital at ris sthat they internalize the inefficiency of ga!#ling or investing in high-ris assets Dhile investing in ga!#ling asset can yield high private returns for the #an if the ga!#le pays off( it i!poses costs odepositors if the ga!#le fails( 'here the pro#a#ility of failure is high. )n contrast( invest!ent in a prudent olo'-ris asset yields higher e2pected returns.

Capital re3uire!ents reduce ga!#ling incentives and !oral hazard #y putting #an e3uity at ris. 0o'ever(they also reduce #ans* franchise values( thus encouraging ga!#ling or G#etting the #anG. )t follo's thatcapital-re3uire!ent regulation is not enough to yield areto-efficient outco!es. Adding other for!s ofregulatory instru!ents can achieve areto-efficient outco!es if they facilitate prudent invest!ent #yincreasing franchise values. Such regulatory policies 'ould see i!proving #an profita#ility. 0igher profiti!ply higher franchise values and so higher incentives for !aing good loans or investing in prudent assets(there#y reducing the !oral hazard pro#le! in #aning. Hote that the franchise value can only #e captured ifthe #an stays in #usiness5 if the #an ga!#les and fails( it loses its franchise value. 6ranchise value can #evie'ed as an intangi#le capital 'hich aug!ents the #an*s e3uity capital.

egulatory policies that could #e used to generate i!prove!ents over using capital re3uire!ents aloneinclude portfolio restrictions( enhancing supervision( and the design of incentive-co!pati#le safety nets. Thgoal of these policies is to li!it the scope of the #an engage!ent in ga!#ling activities and !oral hazard#ehavior 'hile creating 9franchise value incentives for prudential #an #ehavior 9


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(i) Reserve and Liquidity Requirements

To reduce the i!plicit ta2 on #aning activity( the non-interest-#earing reserve #alances held #y #ans at thC4E 'ere reduced 9fro! < percent to $< percent of total Egyptian pound deposits. 8n the other hand(#ans continued to hold 'ith the C4E $< percent of total foreign currency deposits as a reserve #alanceearning interest e3uivalent to ,)48. Mean'hile( the li3uidity ratio 'as reduced and its scope 'as 'idenedthe ratio #eca!e & percent 9do'n fro! 1& percent and < percent for local- and foreign-currency #alancesrespectively. The li3uidity ratio 'as also e2tended to #usiness and invest!ent #ans in addition to

co!!ercial #ans.

Although the reserve and li3uidity ratios are lo'er than the re3uire!ents in the pre-refor! period( they arestill relatively high #y international standards. This !ay reflect the authorities concern a#out the lo'capitalization and solvency of so!e #ans. 4ut strengthening the solvency of 'ea #ans 'ould #e #ettertacled through capital re3uire!ents and loan provisioning 9instead of levying i!plicit ta2 on all #ansindiscri!inately in the for! of high reserve and li3uidity re3uire!ents.

(ii) Capital Adequacy Ratio

The #ans* !ini!u! capital re3uire!ents vis-a-vis their ris 'eighted assets 'ere increased to F percent

along the lines of 4asle Co!!ittee on 4aning Supervision5 Appendi2 )) sho's the classification of assetsand ris 'eights. Capital 'as defined to consist of t'o co!ponents:

a. ri!ary capital( 'hich includes paid-up capital and reserves.

#. 8ther capital( 'hich includes provisions for general #aning riss and su#ordinated long-ter! loans of atleast five-year !aturity 9these loans 'ould #e a!ortized over the last five years of their !aturity period at thrate of & percent per annu!.

As a general rule( one-half of the capital ade3uacy ratio 'ould #e !et fro! pri!ary capital. )n addition( theprovisions for general #aning riss 'ould account for no !ore than $.< percent of the ris 'eighted asset

and the su#ordinated loans should not e2ceed


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e2posure li!it.

(iv) Investment Concentration Aroad

)nvest!ent a#road #y #ans is su#"ect to a li!it of ;& percent of the #an capital. Also( the #an*s depositsheld 'ith single foreign correspondents should not e2ceed $& percent of total invest!ents a#road 9or US1!illion( 'hichever is higher.

(v) Credit Concentration

Single custo!er e2posure7credit facilities( #onds and share holdings7'as li!ited to 1& percent of #ancapital 9on the 4asle definition. At the sa!e ti!e( credit to a single custo!er should not e2ceed < percentof a #an*s paid-up capital and reserves. This applies to all #an #orro'ers including the pu#lic sector onesDhen first applied in $%%$( so!e #ans 'ho e2ceeded this li!it 'ith a 'ide !argin 'ere allo'ed a gradualco!pliance. )n addition( to discourage lending to insiders( #ans are prohi#ited fro! granting any creditfacilities to !e!#ers of their #oard of directors or to their auditors. There is also surveillance #y the C4E ongeographical and sectoral concentration of #an lending so as to diversify portfolio ris.

6or e3uity holdings( #an participation in the share capital of "oint-stoc co!panies is li!ited to ;& percent

of the co!pany*s capital( provided that the no!inal value of the shares o'ned #y the #an shall not e2ceedits paid-up capital and reserves.

(vi) Loan Classi!ication and "rovisioning

Stricter loan classification and provisioning criteria 'ere issued to ensure that individual #ans act prudentlyHon-perfor!ing loans are classified as su#standard( dou#tful( or #ad according to the delay in de#trepay!ent. All types of #ans are !andated to tae provisions on non-perfor!ing loans as follo's:

9a )f interest or principal repay!ent is delayed for over three !onths 9su#standard de#t( a &percent provision has to #e taen.

9# )f unfulfill!ent of de#t-servicing o#ligations e2tends to over si2 !onths 9dou#tfulde#t( the provision increases to


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that total provisions cover a#out F. percent of non-perfor!ing loans. Also( ris-'eighted capitalization isesti!ated at $&.< percent co!pared to the 4asle Co!!ittee*s !ini!u! re3uire!ent of F percent 9F.

ecent #aning pro#le!s suggest( ho'ever( the need for a !ore effective i!ple!entation of the upgradedregulatory syste! and internal controls. )n &&&( a court case of illegal #aning practices sentenced #anofficials and pro#le! #orro'ers to prison for fraud and e!#ezzle!ent. Also( in $%%%-&&&( the #aningsector faced serious li3uidity pro#le!s related to e2cessive ris concentrations 9nota#ly( loans to the realestate sector and increased levels of non-perfor!ing loans. The li3uidity pro#le!s have reduced the #ans*

capacity for financial inter!ediation 'ith negative repercussions on the country*s gro'th prospects.Conse3uently( depositors and potential #orro'ers have thro'n criticis! onto the C4E for not sufficiently!onitoring the #ans( thus under!ining pu#lic confidence in financial sta#ility9%. 4an supervision and theenforce!ent of prudential regulations for solvency purposes is discussed ne2t.

The safety and soundness of the #aning syste! is i!portant not only #ecause it prevents econo!icdo'nturns related to financial panics #ut also #ecause it avoids adverse #udgetary conse3uences forgovern!ents( 'hich often #ear a significant part of the costs of the #ailout. rudential regulation is !eant toprotect the #aning syste! fro! these pro#le!s #y inducing #ans to invest prudently. 8ne for! ofprudential regulation is capital re3uire!ents( typically using the 4an of )nternational Settle!ents 94)Sstandards of the 4asle Accord. Capital re3uire!ents force #ans to have !ore of their o'n capital at ris sothat they internalize the inefficiency of ga!#ling or investing in high-ris assets Dhile investing in aga!#ling asset can yield high private returns for the #an if the ga!#le pays off( it i!poses costs ondepositors if the ga!#le fails( 'here the pro#a#ility of failure is high. )n contrast( invest!ent in a prudent orlo'-ris asset yields higher e2pected returns.

Capital re3uire!ents reduce ga!#ling incentives and !oral hazard #y putting #an e3uity at ris. 0o'ever(they also reduce #ans* franchise values 9i.e.( the capitalized value of e2pected future profits( thusencouraging ga!#ling or G#etting the #anG. )t follo's that capital-re3uire!ent regulation is not enough toyield areto-efficient outco!es. Adding other for!s of regulatory instru!ents can achieve areto-efficientoutco!es if they facilitate prudent invest!ent #y increasing franchise values. Such regulatory policies 'oulsee i!proving #an profita#ility. 0igher profits i!ply higher franchise values and so higher incentives for!aing good loans or investing in prudent assets( there#y reducing the !oral hazard pro#le! in #aning.Hote that the franchise value can only #e captured if the #an stays in #usiness5 if the #an ga!#les and failit loses its franchise value. 6ranchise value can #e vie'ed as an intangi#le capital 'hich aug!ents the #ane3uity capital.

egulatory policies that could #e used to generate i!prove!ents over using capital re3uire!ents aloneinclude deposit-rate ceilings( portfolio restrictions( entry restrictions( and enhancing supervision. The goal othese policies is to li!it the scope of the #an engage!ent in ga!#ling activities and !oral hazard #ehavior'hile creating 9franchise value incentives for prudential #an #ehavior. overn!ents !ay consider theapplication of an opti!al !i2 of these policies. )n this paper( ho'ever( our focus is on enhancing supervisioand ensuring prudent !anage!ent of the #aning fir! #ased on internal controls as a policy instru!entdesigned to align the private incentives of !aret players 'ith the social goal of financial sta#ility.%

)ncentives for prudence in #an #ehavior can protect financial sta#ility( especially in econo!ies 'here the#aning syste! role in do!estic finance is predo!inant( such as in Egypt. )n particular( the returns oninvest!ents to set up rules( institutions( and enforce!ent !echanis!s can #e greater if !aret players havean incentive to align their o'n o#"ectives 'ith the social goal of financial sta#ility. E!phasizing incentives not to deny the i!portance of good rules( capa#le regulators( and strong enforce!ent !easures. 6or e2a!plsafety nets to reduce syste!ic ris should !ini!ize the !oral hazard fro! staeholders #y li!iting risprotection and #y !aing the cost of protection sensitive to the ris taen.

Bank Supervision and Information Disclosure


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Surveillance of the #aning syste! is the responsi#ility of the C4E and co!prises on-site and off-sitesupervision. 8n-site inspection involves visits to the #ans to revie' their financial condition and evaluatetheir !anage!ent controls. 8ff-site surveillance( on the other hand( involves regular assess!ent and analysiof #an perfor!ance #ased on the calculation of screening financial ratios for the different types of #aninginstitutions. The screening ratios chec such pri!ary deter!inants of financial soundness as earnings( asset3uality( li3uidity( and capital ade3uacy. 4ased on this surveillance( the C4E*s #oard of directors are eptregularly infor!ed of develop!ents in the #aning industry through reports prepared #y the supervisorystaff.

4an supervisors are trained on #oth on-site and off-site supervision and participate in regular trainingprogra!s. Hevertheless( the enforce!ent of prudential regulations is 'eaened #y understaffing andunattractive co!pensation for the supervisors. 8n-site inspection used to focus on #an co!pliance 'ith ane2tensive array of credit and tariff controls. Dith the financial refor!s of the early $%%&s and the shift toprudential regulations( greater e!phasis has #een placed on assessing #an solvency and li3uidity. 4ut thefre3uency and intensity of inspection !ay not #e up to the re3uire!ents of the ne' #aning environ!ent. Apresent( it taes the C4E nearly t'o years to conduct on-site inspection of all #ans. This is infre3uent #yinternational standards 9$&. Also( the C4E e2a!iners !ay lac the necessary sills for an effectiveassess!ent of ris !anage!ent techni3ues in #ans and close e2a!ination of the #ans* co!pliance 'ithregulations( particularly 'ith regard to asset 3uality as the recent #aning and li3uidity pro#le!s suggest. Toensure sound and safe #aning practices( there is need to develop appropriate policies for recruiting andretaining a#le staff in #an e2a!ination and supervision. )n particular( #an supervisors should #e offeredattractive salaries and #e trained on !odern practices to i!prove their sill levels.

6or off-site surveillance( the #ans are re3uired to su#!it various prudential and statistical returns to theC4E*s 4an Control epart!ent on a !onthly #asis. These returns are analyzed #y the C4E e2a!iners on #an-#y-#an #asis. 6or the !ost part( the returns are revie'ed !anually due to lac of co!putationalfacilities. A !ore efficient surveillance re3uires a co!puter !onitoring syste! for the supervisors to o#taininfor!ation and identify changes in the financial condition of #ans in a ti!ely fashion. )t 'ould facilitate9$$:

i. Screening financial ratios and identifying those #ans in the #otto! percentile of a peer group.

ii. Screening financial ratios and co!paring the! to critical values.

iii. Co!#ining ratios into a co!posite score( to #e used for raning #ans 9e.g. CAME,-type rating syste!

Auto!ated and electronic reporting under offsite supervision 'ould i!prove the a#ility of the C4E toidentify e!erging pro#le! #ans and to prevent failure. The C4E recently applied the CAME, rating syste#ut it needs to e2tend this practice as only very fe' #ans have #een rated thus far.

There is so!e degree of coordination #et'een on-site and off-site supervision. )f the returns sho'unfavora#le trends for a #an( this #an is contacted for an e2planation and( 'here appropriate( is su#"ectedto on-site inspection #y the C4E e2a!iners. 6or e2a!ple( 'hile there are no stipulated rules for the !aturity!is!atch of assets and lia#ilities in either local or foreign currency( it is analyzed #y the e2a!iners to contr#an ris. )f the !aturity !i2 e2ceeds safe li!its( the C4E notifies the #an !anage!ent of this and follo'up the !atter through on-site inspection. 0o'ever( !ore effective coordination #et'een on-site and off-sitesupervision 'ould re3uire upgrading the infor!ation technology and staff sills. )n this regard( infor!ationprocessing need to #e auto!ated through a co!puter net'or lining all #aning institutions 'ith the C4E9to o#tain and !onitor infor!ation in a ti!ely !anner and the recruit!ent of high cali#re staff should #ee!phasized. The trained and e2perienced C4E e2a!iners should also #e retained through attractiveco!pensation pacages.The C4E also relies on #an e2a!inations conducted #y e2perienced e2ternalauditors under its o'n guidelines. The C4E re3uires each #an to appoint t'o e2ternal auditors 9'ho en"oythe confidence of C4E to e2a!ine the #an*s accounts and prepare an annual report. The auditors should


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notify the #an and C4E of any violation to #aning regulations and report on the degree of ade3uacy of the#an*s internal control syste! e.g. ris-!anage!ent procedures and of provisions. They should also indicatthe techni3ues used for appraising asset 3uality and !anage!ent. At this point( it is to #e !entioned that theaccounting standards !ight differ a!ong auditors !aing it difficult to the C4E to assess and co!pare #anperfor!ance cross-section 'ise and over ti!e. This is specially pronounced in the case of pu#lic sector #an'hich are audited #y the govern!ent*s Central Audit 8rganization 9C8A in addition to the e2ternalauditors.

8n the !aret transparency front( pu#lic disclosure of financial infor!ation 'as generally poor. 4efore fisc$%%F( #ans used to pu#lish their financial state!ents only at the end of fiscal year. Mean'hile( the inco!estate!ents of so!e #ans( especially the state o'ned( 'ere e2ceedingly #rief 'ith a couple of lines onrevenues and e2penditures 'hich do not sho' the a!ount of provisions. The general pu#lic had !orefre3uent access to infor!ation only for #ans 'hich are listed on the stoc e2change. These #ans are!andated #y the capital !aret la' 9,a' %$%% to su#!it 3uarterly state!ents on their financial positionto the Capital Maret Authority( 'hich sells the infor!ation to the interested pu#lic.

The adoption of unifor! accounting and auditing standards and practices #esides sharp i!prove!ents infinancial disclosure 'as !uch needed. rogress on this front 'as necessary: 9a for the regulatory staff to!ae policy reco!!endations and address pro#le!s on sound #asis( and 9# to i!prove corporategovernance in #ans. )n response( the C4E too a decision in $%%= !andating all #ans to adopt internationaccounting standards 9)AS in preparing their financial state!ents 'ith !ore fre3uent disclosure to i!provetransparency of the #aning sector. Starting fiscal $%%F( the #ans are !andated to prepare 3uarterlystate!ents on their financial position and profit>loss account and to pu#lish these in 'idely circulatedne'spapers. The end-of-year state!ent 'ould include detailed infor!ation 'hile the state!ents of thepreceding three 3uarters 'ould #e #rief.

Iet( efforts !ay #e needed to strengthen institutional standards and accounta#ility in the auditing profession9$. etailed audits #ased on accurate( for'ard-looing assess!ent of the #ans* asset 3uality are essentialfor a true evaluation of financial via#ility. Also( 'hile the C4E re3uests the su#!ission of !onthly financiastate!ents #y individual #ans for !onitoring the #aning sector*s perfor!ance( !aret transparency is sofar insufficient. 6or instance( there is no pu#lished data on such i!portant infor!ation as non-perfor!ingloans( average rates of return( and ris-'eighted capitalization. reater and !ore fre3uent pu#lic disclosureof infor!ation7under unifor! and internationally accepted accounting practices7'ould allo' effective!onitoring sche!es of #an #ehavior #y staeholders and esta#lish !aret discipline.

Bank Compliance and Enforcement of Regulations

4an co!pliance and the enforce!ent of prudential regulations can #e checed #y looing at such financialsolvency !easures as the ratio of provisions to loans. )t should #e noted( ho'ever( that provisions cover othuses( such as asset price volatility( and not "ust loans. )n the a#sence of infor!ation #reado'n on specificprovisions( it is difficult to assess the sufficiency of the level of loan provisioning in Egyptian #ans. Iet(given the high leverage ratio in the #aning fir!( loan provisions nor!ally account for the larger part of tota#an provisions. )n this sense( the ratio of provisions to loans still provides a fair reflection of #an solvency

6igure $ sho's the develop!ents of the provisions-to-loans ratio for all #ans in Egypt over the period $%%%%. There is a general up'ard trend especially in the early $%%&s 'hich represents the initial period ofapplying the stricter loan classification and provisioning criteria. State #ans and s!all private #ansgenerally used to understate the reported loan-loss provisions and overstate earnings. 6ollo'ing tighterregulations( ho'ever( the #ans had to #uild up provisions to co!pensate for previous understate!ents.

)nsert 6igure $ here

The C4E*s loan grading and provisioning re3uire!ents as outlined a#ove are perceived #y the specialized


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9state #ans as e2cessive. Dhile consistent 'ith international practice( strict i!ple!entation of such aregulatory sche!e 'ould depress profita#ility and significantly reduce the lending activity. The specialized#ans note that their loan portfolio is distinct fro! other types of #ans in #eing predo!inantly long-ter!and targeting certain sectors 'ith develop!ental o#"ectives. The assu!ed credit ris !ay #e considera#le#ecause of the high sectoral concentration and cyclical patterns in the specific !arets served #ut theyusually possess ade3uate collateral( !ainly real estate and capital e3uip!ent. Iet( if a #orro'er*s cash flo'operations are te!porarily insufficient to !eet de#t o#ligations( 'hich !ay #e caused #y pro"ect overruns inter!s of co!pletion ti!e( the lending #an has to #uild up provisions even 'hen it controls a guaranteedsource of repay!ent. The C4E*s point of vie' is that insofar as the pledged collateral !ay not #e easilyli3uidated( the collateral*s collection value is uncertain particularly 'ith the slo' and e2pensive proceduresof the co!!ercial "udicial syste! in Egypt 9$1.

The need for an effective "udicial syste! 'here co!!ercial disputes can #e rapidly resolved and contractsenforced is perceived. A legal infrastructure in support of #an lending 'ith appropriate legislation relatingto #anruptcy and collateral is dee!ed necessary for a 'ell-functioning #aning syste!. )!prove!ent ofar#itration institutions in Egypt is also sought as a relatively faster alternative for dispute resolution. )t isnote'orthy that in ans'er to these de!ands( the govern!ent issued in $%%% a ne' #ill 'hich 'ould sti!ulaco!!ercial life.

Against this #acground( the specialized #ans have 'idened the scope of their operations to i!prove theperfor!ance and tae account of the changing !aret conditions. 6or e2a!ple( they e2pand on trade finanrelated to the sectoral activities of their clients( introduce lending services to non-traditional custo!ers und#roader definitions of their develop!ental tass( and increase self dependence in fund raising through #onissues and attractive yields on ti!e deposits 'hich are i!portant for !ediu!- and long-ter! lending. Dhithe authorities !ay vie' these develop!ents as favora#le to a !ore co!petitive syste!( this actually entaia !ove to'ards despecialization as the portfolio #ehavior of specialized #ans 'ill #e si!ilar to that ouniversal ones.

The pu#lic sector co!!ercial #ans also have difficulties in i!ple!enting the C4E*s regulations on pro#le!loans. This ste!s fro! the high share of lending to pu#lic enterprises in their loan portfolio. 4efore theenact!ent of ,a' &1>$%%$ 'hich reorganized the pu#lic enterprise sector into financially autono!ousco!panies cut off fro! the fiscal #udget 'ith the ai! of su#"ecting the! to co!petitive !aret forces andprivatization( !any of the pu#lic sector co!panies 'ere not financially via#le and usually reported losses.Their output 'as su#"ect to price controls to !aintain su#sistence-level inco!es for the #ul of thepopulation as part of the social 'elfare sche!e introduced in the early-$%/&s. The pu#lic enterprisesoperating under this syste! used to o#tain cheap credit fro! the state #ans #ut had difficulties servicingtheir de#ts5 they 'ere #orro'ers 'ith high default ris. 4aced #y the govern!ent( the state #ans 'ere notsu#"ected to strict #aning supervision 'ith the result that they had to #uild up su#stantial loan-lossprovisions under the $%%&s refor!s. 4ecause this 'ould adversely affect their profita#ility in the shorter runthe #ans sought a relatively slo' ad"ust!ent to the ne' regulatory regi!e.

The ad"ust!ent process is #elieved to have gathered pace 'ith the use of privatization proceeds for thesettle!ent of pu#lic enterprises inde#tedness and the ensuing i!prove!ent in 3uality of the #ans* loanportfolio. 6urther sti!ulus to the ad"ust!ent process of state #ans 'ould co!e fro! the sales proceeds oftheir shares in profita#le "oint-venture #ans. )t should #e noted( ho'ever( that these shares have providedthe! 'ith a relia#le source of profit 'hile holding large non-perfor!ing loans in pu#lic enterprises.

egarding private #ans( the !a"ority have #een follo'ing prudent lending policies 'ith little difficulty inacco!!odating the strengthened #an regulations. They ad"usted 'ith a reasona#le speed. )n the !eanti!eso!e s!all private sector #ans 'hich are generally undercapitalized lag #ehind in co!plying to theregulations. Mergers #et'een such #ans and #etter !anage!ent !ay allo' the! to survive the ne' policyenviron!ent( favora#le for a !ore co!petitive #aning syste!. )n this conte2t( $< s!all regional #ans 'er!erged in $%%1 into a single institution 9Hational 4an for evelop!ent. Also( the t'o specialized real


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estate #ans !erged in $%%% 9Credit 6oncier Egyptien and Ara# ,and 4an 'ere !erged as the EgypatianAra# eal Estate 4an.

Taing the nature of their e2isting loan portfolios into account( the C4E has #een fle2i#le in the enforce!enof the regulations on pu#lic sector co!!ercial #ans and specialized #ans. They are allo'ed a gradualadaptation to the stricter loan classification and provisioning criteria. Dhile their loan-loss provisions haveincreased( they are #elieved to #e still 'ell #elo' the re3uired levels so as not to depress profita#ility.Si!ilarly( the s!all private #ans are allo'ed a phase-in period. Even though deadlines have #een set for

ad"ust!ent #y the different #ans( it is not o#vious ho' credi#le this can #e5 the ad"ust!ent process lacstransparency.

A !easure of #an perfor!ance 'hich considers provisioning and profita#ility is the provision for loan lossratio5 the higher the ratio of 9annual loan-loss provisions to total operating inco!e the less profita#le the#an is( ceteris pari#us. 6igure sho's the develop!ents of this ratio for different groups of #ans over theperiod $%%$-%F. As can #e seen( the provisions ratio is significantly higher for the pu#lic sector co!!ercial#ans given a large size of non-perfor!ing loans to the state-o'ned enterprises. The lo'er ratios sho'n forthe private #ans and the specialized #ans( 'ho !ainly cater to the needs of the private sector( reflect #etteasset 3uality and profita#ility in these #ans. )t should #e noted( ho'ever( that credit ris in the specialized#ans is nor!ally higher than in the private #ans as they typically lend to #usinesses involved in cyclicalactivities5 e.g.( agriculture and real estate. This suggests 'ea i!ple!entation of the C4E*s loanclassification and provisioning criteria in the specialized #ans as one 'ould e2pect higher provisionratios7at least co!pared 'ith the private #ans7than sho'n in the figure.

)nsert 6igure here

)ntroducing !aret incentives for provisioning !ay speed-up #an ad"ust!ent to the prudential regulations.)n this connection( allo'ing ta2-deducta#ility of loan-loss provisions 'ould provide #ans 'ith incentivesfor #uilding up provisions 'ithout necessarily depressing their profita#ility. At present( ta2 treat!ent of loanlosses in Egypt does not appear to #e providing #ans 'ith incentives for i!proving their financial strengthE2cept for #ad de#t 9as opposed to su#standard and dou#tful de#ts and up to $& percent of net profits( loanloss provisions are not ta2 deducti#le5 inco!e ta2 on #an #usiness is ;& percent. 4ut 'hen a loan ulti!atelproves to #e uncollecta#le and is charged off( a ta2 re#ate is allo'ed. ue to deficiencies in ta2ad!inistration( ho'ever( the re!itted a!ount is usually delayed for years 'ith negative i!pact on #anli3uidity. 9Charge-offs reduce provisions for loan losses( lo'er reported profits( and decrease a #an*s net'orth5 they raise #orro'ing costs on purchased funds. )t 'ould #e helpful to #ans if the efficiency of ta2ad!inistration is i!proved or if provisions are ta2 deducti#le. Such !easures 'ould contri#ute to greater#an loss provisions and higher profits. That is( the a#ility of #ans to a#sor# future losses 'ould i!provetogether 'ith their perfor!ance.

The C4E regulatory syste! is #ased on a purely 3uantitative !ethod applied to all #ans( regardless of theirsize or their individual nature. Under unifor! and international audit standards( the !ain advantage of this!ethod is ensuring a certain transparency in the #aning sector #y providing o#"ective co!parisons. 8n theother hand( it does not sufficiently tae into account asset 3uality and !anage!ent efficiency of the #ans inlight of their #usiness type and principal orientations 9$;. This dra'#ac riss 'ea adherence to theprudential regulations as suggested #y the Egyptian case 'ith respect to the state-o'ned and s!all private#ans. ,oan classification and provisioning rules are( in general( not strictly i!ple!ented #y these #ans. Apractice 'hich is apparently encouraged #y the nondeducti#ility of loan-loss provisions for ta2ation purposeon one hand and #y understaffed 9#oth in ter!s of 3uantity and sill levels C4E e2a!iners on the other. Thlatter casts dou#t on effective enforce!ent po'ers.

To i!prove the enforcea#ility of #aning regulations( the C4E !ay find it 'orth'hile to reconsider theho!ogeneity of the for!s of control given the diversity of #an types. Alternatively( the 3uantitativeregulatory syste! !ay #e reinforced 'ith post-li#eralization #an restructuring directed to'ards universal


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#aning 9despecialization 'ith s!all #ans li3uidated or !erged for #etter portfolio diversification. Dhilethere are potential econo!ies of scale fro! universal #aning( the greater riss involved call for esta#lishingholding co!pany structures 'ith separately capitalized su#sidiaries to carry out such activities as securitiestrading and fund !anage!ent. The increasing nu!#er of #ans in Egypt 'ith holding co!pany structuressuggests a trend to'ards universal #aning 9the nu!#er increased fro! four #ans in $%%; to si2teen in&&&. Transparency of pu#lic policy on the envisaged structure of the #aning syste! should #e e!phasizefor accounta#ility and enforce!ent purposes.

Also( in order for the C4E to properly discipline the #aning sector( #an regulations should #e appliedforcefully. 8n-site and off-site supervision should #e strengthened to send a strong signal to #ans 'hich donot follo' prudent practices and to i!prove solvency of the #aning syste!. A tough stance should #e taen'hen dealing 'ith pro#le! #ans such that only those assessed to #e via#le in the longer ter! 'ould #erestructured #ut under ne' !anage!ent and o'nership5 #ad !anage!ent should not #e re'arded andcorporate governance in the #ans should #e i!proved.

+ust as 'ell-!anaged #ans !onitor their #orro'ers( the authorities can serve depositors #y !onitoring#ans on their #ehalf. overn!ent regulation should go #eyond processing infor!ation and pu#lishing theresults. The regulator !ust not allo' a #an to continue functioning 'hen it is insolvent5 the #an !ay #eli3uidated or !erged into another #an 9$


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deposit protection sche!e. Under the i!plicit sche!e( a central #an !ay act as lender of last resort( thegovern!ent !ay provide funds directly to trou#led #ans( or the govern!ent !ay tae over these #ans andthen guarantees that depositors 'ill receive their !oney in full. The #orro'ers fro! failed #ans also sufferas the infor!ational capital they ac3uired through sustained dealings 'ith the #an suddenly loses its value.

Dhile providing depositors 'ith reasona#le confidence a#out the safety of their !oney( deposit insurance hits dra'#acs. The i!plicit safety net in the case of Egypt is no e2ception. De discuss the infor!ationalpro#le!s associated 'ith different insurance sche!es to dra' conclusions on the design of incentive-

co!pati#le safety nets 'hich !ini!ize !oral hazards 9$=.

6irst( 'e note that if the authorities do not provide ade3uate supervision( #ans 'ith deposit insurance havean incentive to invest in a ga!#ling asset. The #an realizes high private return if the ga!#le pays off'hereas depositors have nothing or little to lose if the ga!#le fails. Dith a safety net( depositors do noti!pose !aret discipline on #ans #y 'ithdra'ing deposits 'hen they suspect that #an !anagers areengaged in ga!#ling activities. Iet( in the event of #an failure( the fiscal cost is significant and is eventual#orne #y ta2payers.

To reduce the !oral hazard pro#le!s of safety nets( #an supervision should #e strengthened to ensure that#ans are not taing on too !uch ris. Mean'hile( the authorities should set incentive structures that alignthe private incentives of !aret players 'ith the social good. 6or e2a!ple( in e2plicit insurance sche!es(charging insurance pre!iu!s that vary 'ith the risiness of a #an*s assets can induce #ans to invest inlo'-ris assets( yielding higher e2pected returns. Also( allo'ing the ris-#ased pre!iu!s to drop as the#an*s capital increases encourages the #an to hold !ore capital( 'hich has the #enefit of reducing !oralhazard.

8ne pro#le! 'ith ris-#ased pre!iu!s( ho'ever( is that #an regulators !ay have difficulty in accuratelyassessing the risiness of a #an*s assets. The classification of #ans #y such !easures as the 4asel ris-#ased capital standard solely reflects credit ris and does not tae sufficient account of interest-rate ris.Accordingly( ris-#ased standards should #e !odified to include interest-rate ris and regulators should setguidelines to encourage #ans to !anage interest-rate ris.

Second( e2plicit deposit insurance sche!es can tae a variety of for!s 'ith regard to their ad!inistration anfinancing( ranging fro! pure private syste!s to pure pu#lic ones. A 3uasi-pu#lic syste! 'hich is "ointly!anaged and funded #y the govern!ent and the #ans is liely( ho'ever( to achieve the insurance fundo#"ective of preserving pu#lic confidence in the #aning industry !ore effectively. A pure pu#lic syste!entails a su#sidy to #ans 'hile a pure private one i!poses a ta2 on #ans and !ay #rea do'n( particularlyin ti!es of #aning pro#le!s 'ith high resolution costs7i.e.( "ust 'hen the syste! is !ost needed. )ncontrast( a 3uasi-pu#lic syste! 'ith govern!ent financial #acing provides a !ore appealing cost-sharingand incentive-co!pati#le structure that can reduce !oral hazard and preserve pu#lic confidence.

Third( unless the !e!#ership of #ans in e2plicit insurance sche!es is !andatory( only the 'eaer #ans'ill participate in the sche!e 'ith adverse selection conse3uences. 6or the sche!e to #e ade3uately fundedand financially via#le( the cost of insurance should #e shared a!ong all #ans. This surely entails a crosssu#sidization of the 'eaer #ans out of the financially sound ones. Iet( all #ans 'ould #enefit fro! havina !ore sta#le industry 'here the lielihood of #an panics is reduced 9$F.

6ourth( 'ith a safety net in 'hich deposits are fully insured( large depositors 'ould lose incentive for!onitoring #ans and esta#lishing !aret discipline. Dhatever the risiness of #an assets is( depositors 'inot suffer any losses if all deposits are fully guaranteed. This !ay encourage #ans to tae on greater riss(there#y increasing the lielihood of #an failures and financial insta#ility. Dhile a co!plete depositinsurance eli!inates the riss of #an runs( it destroys the value of infor!ation production and !onitoring #depositors for sound #aning practices and financial sta#ility.


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)n contrast( an e2plicit deposit insurance sche!e in 'hich depositors are paid off only up to a certaininsurance li!it can induce #ans to engage in prudent ris taing. Under such a sche!e( large depositors9holding accounts in e2cess of the deposit insurance li!it 'ould have an incentive to !onitor #an #ehavioand pull out their deposits 'hen the #an taes on too !uch ris. To prevent a significant loss of deposits ana possi#le related decline in franchise value( the #an 'ould #e !ore liely to invest prudently.

6ifth( an a!#iguous safety net in the for! of an i!plicit deposit insurance sche!e 9'hich is #aced #y thegovern!ent !ay desta#ilize the #aning syste! #y encouraging e2cessive ris taing and under!ining

!aret discipline. Dhile a!#iguity !ay #e i!portant to deter !oral hazard incentives( it !ay lead toregulatory for#earance in the face of #aning pro#le!s. The regulator !ay #e reluctant to adopt transparentand clear rules for resolving #aning pro#le!s5 e.g.( putting a #an out of #usiness if it is insolvent.

)n particular( the regulator !ay need to refrain fro! i!ple!enting these rules 'hen it #elieves that there isris of un"ustified closure of a #an #ecause of inco!plete infor!ation on its true solvency 9for instance(#ecause of deficiencies in accounting infor!ation. )n order not to i!pair its credi#ility in such a situation(the regulator !ay prefer a!#iguous #ut credi#le rules over transparent rules that lac credi#ility. The scopefor a!#iguity has #een declining( ho'ever( 'ith trends to'ards greater disclosure of #aning infor!ation9$%.

egulatory for#earance can also arise fro! agency pro#le!s( 'hich occur 'hen the agent 9the regulatordoes not have the sa!e incentives to !ini!ize costs to the econo!y as the principal 9the ta2payer.egulators are ulti!ately agents for ta2payers 9principals 'ho #ear the cost of any losses #y a depositinsurance sche!e. To act in the ta2payer*s interest and lo'er costs to a deposit insurance sche!e( theregulator !ust enforce prudential regulations and !ust not adopt a stance of regulatory for#earance( 'hichallo's insolvent #ans to continue to operate. 0o'ever( the regulator !ay lac ade3uate incentives to act inthe ta2payer*s interest.

The regulator*s desire to hide the pro#le! of an insolvent #an on the hope that the situation 'ill i!prove(and hence escape #la!e for poor perfor!ance in #an supervision( !ay #e higher than their desire to i!posregulations under the e2isting incentive sche!e. This !ay happen 'hen the regulatory #ody is understaffedand poorly paid such that #an supervisors are prone to regulatory capture. )n this case( the supervisors servthe #ans rather than the interests of depositors and ta2payers. )n particular( an insolvent #an !ay offerattractive honoraria to supervisors to adopt a stance of regulatory for#earance( There #y aligning the #an*sincentive to #et the #an 'ith the supervisors* incentive for greater co!pensation.

To reduce the danger of regulatory capture( the regulatory #ody should #e ade3uately staffed( #oth in ter!sof 3uantity and sill levels( and supervisors should #e handso!ely co!pensated. 6or the regulatory #ody toattract and retain 3ualified staff( trained to !aintain their pu#lic responsi#ilities 'hen carrying out theirsupervisory duties( co!pensation should #e co!petitive 'ith the private sector. E2e!pting #an supervisorfro! govern!ent salary scales !ay have less #udgetary cost than a #an failure 9&.

)n Egypt( financial difficulties of individual #ans have #een !et #y the govern!ent in an ad hoc !anner.6or e2a!ple( in $%%$( a "oint venture #et'een 4an for Credit and Co!!erce )nternational 94CC) and alocal partner faced solvency pro#le!s that led to govern!ent intervention to protect the depositors* funds.The C4E first re3uested other #ans to lend support in the for! of an interest-free loan e3uivalent to &.

incentive-based regulations and bank restructuring in egypt

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