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Incentive-Based Regulations and Bank Restructuring in Egypt

Alaa El-Shazly Cairo University E-Mail: ashazly@cics.feps.eun.eg Summary

The Egyptian authorities undertoo !a"or #an ing refor!s in the $%%&s to'ards a !ore li#eral syste!. This included the strengthening of #an supervision and regulations on the #asis of internationally accepted standards to deal 'ith the ris s inherent in the ne' policy environ!ent. To ensure the sta#ility of the #an ing industry( the regulatory policy should include ele!ents of private !ar et discipline along 'ith strong enforce!ent !echanis!s of prudential #an regulation. The safety nets should #e #ased on rules designed to align the private incentives of !ar et players 'ith the social goal of financial sta#ility. )ncentives for prudence and safe #an ing practices can protect !ar et sta#ility and increase the #an s* franchise values +E, Codes: -.( E/( 01

1. Introduction )n recent decades( !any countries have e2perienced #an ing pro#le!s re3uiring !a"or refor!s of their #an ing syste!s. The pro#le!s are largely due to do!estic causes( such as 'ea #an ing supervision and inade3uate capital. Also( #an ing refor! !ay #e needed to !odernize the financial services industry( as in the case of transition countries !oving fro! a pu#lic-sector-led to a !ar et econo!y. E2ternal factors( such as deteriorating ter!s of trade( can cause currency crises and 'orsen #an ing 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 #an ing distress( depositors and o'ners of #an capital all lose confidence and see si!ultaneously to salvage their resources #y 'ithdra'ing the!. This leads to #an ing panic and the authorities have no option #ut to restore sta#ility 'ith policy re!edies that are !ore difficult and costly under a #an ing crisis. -overn!ents can do #etter( ho'ever( #y anticipating the need for refor!s and carrying the! out in ti!es of relative financial cal!. Countries resolve their #an ing pro#le!s #y adopting strategies( policies( and tools for refor! and successful restructuring. 4an restructuring ai!s to i!prove #an perfor!ance5 that is( restore solvency and profita#ility( i!prove the #an ing syste! capacity to provide financial inter!ediation #et'een depositors and #orro'ers( and restore pu#lic confidence. This re3uires a co!prehensive approach fro! policy!a ers in addressing #an ing 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 synchronized application can #ring a#out a !ore efficient 'or ing of the #an ing syste!. 6inancial restructuring atte!pts to restore solvency #y i!proving #an s* #alance sheets or net 'orth7e.g.( #y raising additional capital or #y raising the recovery value of pro#le! loans and collateral. 8perational restructuring affects profita#ility 'ith

such !easures as i!proved !anage!ent and accounting syste!s( and #etter assess!ent of asset ris . 6inally( enhancing supervision and prudential regulation as 'ell as esta#lishing safety nets( such as deposit insurance( raise pu#lic confidence and add to the #an ing 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 incentives of !ar et players 'ith the social goal of financial sta#ility. )ncentives for prudence and safe #an ing practices can protect !ar et sta#ility and increase the #an s* franchise values 9i.e.( the capitalized value of e2pected future profits:. Thus govern!ents should introduce ele!ents of private !ar et discipline as a !a"or co!ponent of the regulatory regi!e along 'ith good rules and strong enforce!ent !echanis!s. Si!ilar to !any e!erging !ar et econo!ies( Egypt undertoo #an ing sector refor!s in the $%%&s to'ards a !ore li#eral syste!. The ne' policy environ!ent necessitated refining the !ethods used in !onitoring ris s 'ith e!phasis on prudential #an regulation. The present paper sheds light on #an regulatory policy in Egypt 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 #an ing syste!. Section 1 focuses on prudential regulation and #an supervision and highlights i!pedi!ents to stronger enforce!ent !echanis!s. Section ; discusses different sche!es for !onitoring #an #ehavior under infor!ational asy!!etries and the design of incentive-co!pati#le safety nets. Section < provides econo!etric evidence on #an heterogeneity and !ar et discipline. Section / concludes.

2. The Egyptian Banking System: Structure and ompetition The Egyptian #an ing sector e2panded !ar edly in the !id-$%=&s spurred #y the country*s so-called open door policy. This policy ai!ed at out'ard-loo ing gro'th 'ith an active role for the private sector to pro!ote econo!ic perfor!ance. To serve the ne' policy( a #an ing la' 'as enacted in $%=< 9,a' $.&>$%=<: defining the nature and !ode of operations for all #an s. )t identified three types of #an s: 9i: Co!!ercial #an s( 'hich usually accept deposits and provide finance for a 'ide variety of transactions. 9ii: 4usiness and invest!ent #an s( 'hich carry out !ediu!- and long-ter! operations such as the pro!otion of ne' #usinesses and financing of fi2ed asset invest!ents. They !ay also accept deposits and finance foreign-trade operations. 9iii: Specialized #an s( 'hich carry out operations serving a specific type of econo!ic activity. They !ay accept de!and deposits. 4an s operating in Egypt can also #e classified as pu#lic sector( private ? "oint venture( or foreign according to o'nership. All specialized #an s are state o'ned and are assigned the tas of providing long ter! finance for real estate( agricultural and industrial develop!ent. They !ainly cater to the needs of the private sector and depend in their fund raising on #orro'ing fro! financial institutions. There are also four pu#lic sector co!!ercial #an s and 'hose volu!e of #usiness constitutes a significant share in total #an transactions. @rivate ? "oint venture as 'ell as foreign #an s 9operating through #ranches: are private sector institutions esta#lished under invest!ent la'. 6oreign #an s are all registered as #usiness and invest!ent #an s as their envisaged role is principally to raise long-ter! funds on the international financial !ar ets and to pro!ote invest!ent. )n addition( there are #an s 'hich are esta#lished under special la's and 'hich are not registered 'ith the Central 4an of Egypt 9C4E:. Appendi2 ) sho's structure of the Egyptian #an ing syste! and #alance-sheet size of #an s. As can #e seen( co!!ercial #an s account for the #ul of #an ing operations. The four pu#lic sector co!!ercial #an s are the largest operating #an s in Egypt in ter!s of #alance-sheet

size( accounting for nearly <& percent of total #an assets. They have a significant !ar et share in retail and corporate #an ing services through large #ranch net'or s and close relationship 'ith state-o'ned co!panies. They are also !a"or participants in the e3uity capital of !ost "oint-venture #an s. The private #an s play a less do!inant role in the !ar et for loana#le funds and focus on trade-related financial services to the private #usiness sector. They have sho'ed a preference to finance 'or ing capital and trade activities 'hose transactions nor!ally re3uire short ter! credit and result in 3uic er and !ore secure returns. )n practice( the portfolio #ehavior of the private co!!ercial #an s and of the #usiness and invest!ent #an s are virtually the sa!e. The #an ing industry is therefore concentrated and seg!ented( and this has a stifling effect on co!petition. The private #an s are see ing 'ays( ho'ever( to further diversify their loan portfolio and assets as opposed to focusing on trade finance. They have recently reassessed their financial services and 'idened their retail #ase 'ith a vie' to !eet their clients* de!and for personal loans( !ortgages( insurance products( individual retire!ent plans( and credit cards.9.: Aegulatory #arriers to entry also 'ea en co!petition in the #an ing industry. The C4E is apparently reluctant to license ne' do!estic #an s as it regards the nu!#er of e2isting ones large enough for esta#lishing a co!petitive !ar et. The C4E*s reluctance to issue ne' licenses is reflected in the high entry costs( 'hich are e2cessive #y international standards.91: The !ini!u! authorized capital for ne' #an s is set at BE $&& !illion( of 'hich BE <& !illion has to #e fully paid up 9BE denotes Egyptian pound5 theses figures are e3uivalent to a#out USC 1& !illion and USC $< !illion( respectively:. 6or #ranches of foreign #an s( ho'ever( the !ini!u! authorized capital is set at USC $< !illion or the e3uivalent in other !a"or currencies. )t is also alleged that the C4E does not particularly favor an e2pansion of the private #an s* #ranch net'or in locations already do!inated #y the pu#lic sector #an s in the !a"or cities. Dhile there appear no restrictions on #ranching in locations 'hich are deprived of ade3uate #an ing services such as the ne' co!!unities and the provinces( the pu#lic sector #an s continue to !aintain a large !ar et share. )n particular( since the opening of #ranches is influenced #y the e2pected level of #usiness activity( 'hich is nor!ally higher in the city( #ranches of the private #an s are considera#ly outnu!#ered #y #ranches of the pu#lic sector #an s. At end-Eece!#er $%%%( the private #an s had ;F$ #ranches nation'ide co!pared to %$F #ranches for the pu#lic sector co!!ercial #an s. Aecently( in an atte!pt to reduce !ar et concentration and enhance co!petition( the authorities have i!ple!ented a #an privatization progra!. The pu#lic sector #an s are !andated to divest their shares in the "oint-venture #an s 'ith a !a2i!u! o'nership of .& percent. 4y end-+une .&&&( the pu#lic #an s* o'nership 'as a#ove .& percent in eight 9out of t'enty three: "oint-venture #an s 'hose privatization 'as planned to #e co!plete #y the end of the sa!e year. The authorities also plan to privatize the four pu#lic sector co!!ercial #an s. The necessary legislation for the privatization of these #an s 'as passed #y the parlia!ent in $%%F( #ut none 'as offered for sale as yet. The pu#lic co!!ercial #an s are unli ely to #e privatized in the current period until #roader financial sector restructuring is underta en( including the strengthening of #an supervision. This reflects the authorities* preference for selling pu#lic #an s after i!proving their financial via#ility to ensure !a2i!u! participation #y 3uality investors and the highest possi#le price.; 2. Bank Regulation and Supervision Prudential Regulations The safety and soundness of the #an ing syste! is i!portant not only #ecause it prevents econo!ic do'nturns related to financial panics #ut also #ecause it avoids adverse #udgetary conse3uences for

govern!ents( 'hich often #ear a significant part of the costs of the #ailout. @rudential regulation is !eant to protect the #an ing syste! fro! these pro#le!s #y inducing #an s to invest prudently. 8ne for! of prudential regulation is capital re3uire!ents( typically using the 4an of )nternational Settle!ents 94)S: standards of the 4asle Accord. Capital re3uire!ents force #an s to have !ore of their o'n capital at ris so that they internalize the inefficiency of ga!#ling or investing in high-ris assets Dhile investing in a ga!#ling asset can yield high private returns for the #an if the ga!#le pays off( it i!poses costs on depositors if the ga!#le fails( 'here the pro#a#ility of failure is high. )n contrast( invest!ent in a prudent or lo'-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 #an s* franchise values( thus encouraging ga!#ling or G#etting the #an G. )t follo's that capital-re3uire!ent regulation is not enough to yield @areto-efficient outco!es. Adding other for!s of regulatory instru!ents can achieve @areto-efficient outco!es if they facilitate prudent invest!ent #y increasing franchise values. Such regulatory policies 'ould see i!proving #an profita#ility. 0igher profits i!ply higher franchise values and so higher incentives for !a ing good loans or investing in prudent assets( there#y reducing the !oral hazard pro#le! in #an ing. Hote that the franchise value can only #e captured if the #an stays in #usiness5 if the #an ga!#les and fails( it loses its franchise value. 6ranchise value can #e vie'ed as an intangi#le capital 'hich aug!ents the #an *s e3uity capital. Aegulatory policies that could #e used to generate i!prove!ents over using capital re3uire!ents alone include portfolio restrictions( enhancing supervision( and the design of incentive-co!pati#le safety nets. The goal 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<:. -overn!ents !ay consider the application of an opti!al !i2 of these policies. )n 'hat follo's( ho'ever( 'e focus on enhancing supervision and the incentive-co!pati#ility of safety nets. These policies 'ould ensure prudent !anage!ent of the #an ing fir! #ased on internal controls. )ncentives for prudence in #an #ehavior can protect financial sta#ility( especially in econo!ies 'here the #an ing syste! role in do!estic finance is predo!inant( such as in Egypt. )ncentive sche!es 'hich align the o#"ectives of !ar et players 'ith the social good should #e an i!portant co!ponent of the regulatory policy. 6or e2a!ple( safety nets to reduce syste!ic ris should !ini!ize the !oral hazard fro! sta eholders #y li!iting ris protection and #y !a ing the cost of protection sensitive to the ris ta en. Hoting this( 'e first revie' the prudential regulations in the Egyptian #an ing syste! #efore considering their actual i!ple!entation and the roo! to i!prove #an regulatory policy. )n Egypt( the central #an is the regulator. The C4E is responsi#le for( inter alia( regulating and !anaging the #an ing and !onetary syste!( and acts as the G#an ers* #an G dealing 'ith the daily settle!ents of clearings. The C4E is also the supervisory authority for deposit-ta ing #an s( 'ith 'ide po'ers vested in it #y the #an ing la'. @rior to refor!s in the early $%%&s( the #an ing sector 'as heavily regulated through credit controls and portfolio restrictions 9/:. A !ove to'ards a !ore li#eral regi!e 'hich e!phasizes prudential regulations and co!petitiveness in the #an ing industry too place in the $%%&s. Aegulations that discri!inate against private #an s and inhi#it a level playing field for all participants 'ere re!oved. 6or e2a!ple( pu#lic sector co!panies 'ere allo'ed to deal 'ith all #an s 'ithout prior per!ission fro! a pu#lic sector #an . 4ranches of foreign-o'ned #an s 'ere allo'ed to operate in local currency and full entry of foreign #an s through the esta#lish!ent of local su#sidiaries 'as authorized. 6oreign partners 'ere allo'ed !a"ority e3uity-holdings in "oint venture #an s. 4an fees and charges( creditor and de#tor rates( and transactions on the foreign e2change !ar et 'ere li#eralized. Ad!inistrative credit allocation 'as phased out and Treasury #ill auctions 'ere used to !anage li3uidity and indirectly provide a reference interest rate to the financial !ar ets. The C4E also too the follo'ing !easures in $%%$ to strengthen the solvency and efficiency of #an s 9=::

(i) Reserve and Liquidity Requirements To reduce the i!plicit ta2 on #an ing activity( the non-interest-#earing reserve #alances held #y #an s at the C4E 'ere reduced 9fro! .< percent: to $< percent of total Egyptian pound deposits. 8n the other hand( #an s continued to hold 'ith the C4E $< percent of total foreign currency deposits as a reserve #alance earning interest e3uivalent to ,)48A. Mean'hile( the li3uidity ratio 'as reduced and its scope 'as 'idened5 the ratio #eca!e .& percent 9do'n fro! 1& percent: and .< percent for local- and foreign-currency #alances( respectively. The li3uidity ratio 'as also e2tended to #usiness and invest!ent #an s in addition to co!!ercial #an s. Although the reserve and li3uidity ratios are lo'er than the re3uire!ents in the pre-refor! period( they are still relatively high #y international standards. This !ay reflect the authorities concern a#out the lo' capitalization and solvency of so!e #an s. 4ut strengthening the solvency of 'ea #an s 'ould #e #etter tac led through capital re3uire!ents and loan provisioning 9instead of levying i!plicit ta2 on all #an s indiscri!inately in the for! of high reserve and li3uidity re3uire!ents:. (ii) Capital Adequacy Ratio The #an s* !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 4an ing Supervision5 Appendi2 )) sho's the classification of assets and 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 #an ing ris s and su#ordinated long-ter! loans of at least five-year !aturity 9these loans 'ould #e a!ortized over the last five years of their !aturity period at the rate of .& percent per annu!:. As a general rule( one-half of the capital ade3uacy ratio 'ould #e !et fro! pri!ary capital. )n addition( the provisions for general #an ing ris s 'ould account for no !ore than $..< percent of the ris 'eighted assets( and the su#ordinated loans should not e2ceed <& percent of pri!ary capital. The C4E decision for the 9F percent: capital ade3uacy ratio 'as ta en in +anuary $%%$. 4an s 'hose capital did not co!ply 'ith the ne' regulations at the ti!e 'ere allo'ed gradual co!pliance: 9a: 6or #an s 'ith capital ade3uacy ratio #et'een = percent and F percent at end-Eece!#er $%%&( they 'ere re3uired to co!ply 'ith the ne' regulations #y end-Eece!#er $%%.. 9#: 6or #an s 'ith capital ade3uacy ratio #elo' = percent at end Eece!#er $%%&( they 'ere re3uired to co!ply 'ith the ne' regulations #y end-Eece!#er $%%1. )t is note'orthy that the pu#lic sector #an s 'ere recapitalized 9through govern!ent #onds: to co!ply 'ith the capital ade3uacy ratio. At present( there are fe' non-co!plying private #an s. The C4E has agreed 'ith these #an s7'hich are s!all( accounting for nearly 1 percent of #an ing assets7on a schedule for co!pliance and a penalty sche!e is developed to ensure progress on this front. (iii) Foreign-Exchange Exposure The #an s foreign-e2change e2posure 'as li!ited5 the ratio of foreign currency lia#ilities to foreign currency assets #eca!e su#"ect to a !a2i!u! li!it of $&< percent( and the open position for a single currency and for all currencies co!#ined #eca!e su#"ect to li!its of $& percent and .& percent( respectively( of #an capital. Dith open position in several currencies( the .& percent li!it represents a cap on the single currency

e2posure li!it. (iv) Investment Concentration A road )nvest!ent a#road #y #an s is su#"ect to a li!it of ;& percent of the #an capital. Also( the #an *s deposits held 'ith single foreign correspondents should not e2ceed $& percent of total invest!ents a#road 9or USC1 !illion( 'hichever is higher:. (v) Credit Concentration Single custo!er e2posure7credit facilities( #onds and share holdings7'as li!ited to 1& percent of #an capital 9on the 4asle definition:. At the sa!e ti!e( credit to a single custo!er should not e2ceed .< percent of a #an *s paid-up capital and reserves. This applies to all #an #orro'ers including the pu#lic sector ones. Dhen first applied in $%%$( so!e #an s 'ho e2ceeded this li!it 'ith a 'ide !argin 'ere allo'ed a gradual co!pliance. )n addition( to discourage lending to insiders( #an s are prohi#ited fro! granting any credit facilities to !e!#ers of their #oard of directors or to their auditors. There is also surveillance #y the C4E on geographical 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 e2ceed its paid-up capital and reserves. (vi) Loan Classi!ication and "rovisioning Stricter loan classification and provisioning criteria 'ere issued to ensure that individual #an s act prudently. Hon-perfor!ing loans are classified as su#standard( dou#tful( or #ad according to the delay in de#t repay!ent. All types of #an s are !andated to ta e 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 ta en. 9#: )f unfulfill!ent of de#t-servicing o#ligations e2tends to over si2 !onths de#t:( the provision increases to <& percent. 9c: for. 9dou#tful

)f the delay in servicing #an de#t e2ceeds a year 9#ad de#t:( a $&& percent provision is called

The C4E e2a!iners !ay also re3uest the classification of certain #orro'ers as high-ris ( and conse3uently !andate increased provisions on the part of #an s. This is intended to cover ris s 'hich are no'n to e2ist #ut 'hich have not #een identified at the #alance sheet date. )n case of provision inade3uacy( the C4E is e!po'ered to prohi#it the #an fro! distri#uting dividends to its shareholders in order to strengthen the #an *s financial position. )n addition( interest accrual on non-perfor!ing loans should #e suspended and appear as footnote to the financial state!ents5 it should not #e added to custo!er de#it #alances. )t is note'orthy that non-perfor!ing loans !ay not #e classified as such if #orro'ers put up highly li3uid collateral 9near !onies: such as #an deposits and Treasury securities 'hich fully guarantee the de#t repay!ent. These prudential regulations are intended to control #an losses through early detection. )n other 'ords( deviations fro! the regulatory fra!e'or serve as early 'arning signals to #an ing pro#le!s. The C4E confir!s that #an s are in co!pliance 'ith the prudential regulations 'ith only a fe' e2ceptions5 nonco!plying #an s are not allo'ed to distri#ute profits until their financial condition is strengthened. 8fficial esti!ates sho' that non-perfor!ing loans declined fro! $;.= percent in $%%/ to $$.= percent in $%%% and

that total provisions cover a#out F... percent of non-perfor!ing loans. Also( ris -'eighted capitalization is esti!ated at $&.< percent co!pared to the 4asle Co!!ittee*s !ini!u! re3uire!ent of F percent 9F:. Aecent #an ing pro#le!s suggest( ho'ever( the need for a !ore effective i!ple!entation of the upgraded regulatory syste! and internal controls. )n .&&&( a court case of illegal #an ing practices sentenced #an officials and pro#le! #orro'ers to prison for fraud and e!#ezzle!ent. Also( in $%%%-.&&&( the #an ing sector faced serious li3uidity pro#le!s related to e2cessive ris concentrations 9nota#ly( loans to the real estate sector: and increased levels of non-perfor!ing loans. The li3uidity pro#le!s have reduced the #an s* 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 #an s( thus under!ining pu#lic confidence in financial sta#ility9%:. 4an supervision and the enforce!ent of prudential regulations for solvency purposes is discussed ne2t. The safety and soundness of the #an ing syste! is i!portant not only #ecause it prevents econo!ic do'nturns related to financial panics #ut also #ecause it avoids adverse #udgetary conse3uences for govern!ents( 'hich often #ear a significant part of the costs of the #ailout. @rudential regulation is !eant to protect the #an ing syste! fro! these pro#le!s #y inducing #an s to invest prudently. 8ne for! of prudential regulation is capital re3uire!ents( typically using the 4an of )nternational Settle!ents 94)S: standards of the 4asle Accord. Capital re3uire!ents force #an s to have !ore of their o'n capital at ris so that they internalize the inefficiency of ga!#ling or investing in high-ris assets Dhile investing in a ga!#ling asset can yield high private returns for the #an if the ga!#le pays off( it i!poses costs on depositors if the ga!#le fails( 'here the pro#a#ility of failure is high. )n contrast( invest!ent in a prudent or lo'-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 #an s* franchise values 9i.e.( the capitalized value of e2pected future profits:( thus encouraging ga!#ling or G#etting the #an G. )t follo's that capital-re3uire!ent regulation is not enough to yield @areto-efficient outco!es. Adding other for!s of regulatory instru!ents can achieve @areto-efficient outco!es if they facilitate prudent invest!ent #y increasing franchise values. Such regulatory policies 'ould see i!proving #an profita#ility. 0igher profits i!ply higher franchise values and so higher incentives for !a ing good loans or investing in prudent assets( there#y reducing the !oral hazard pro#le! in #an ing. Hote that the franchise value can only #e captured if the #an stays in #usiness5 if the #an ga!#les and fails( it loses its franchise value. 6ranchise value can #e vie'ed as an intangi#le capital 'hich aug!ents the #an *s e3uity capital. Aegulatory policies that could #e used to generate i!prove!ents over using capital re3uire!ents alone include deposit-rate ceilings( portfolio restrictions( entry restrictions( and enhancing supervision. The goal 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. -overn!ents !ay consider the application of an opti!al !i2 of these policies. )n this paper( ho'ever( our focus is on enhancing supervision and ensuring prudent !anage!ent of the #an ing fir! #ased on internal controls as a policy instru!ent designed to align the private incentives of !ar et 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 #an ing syste! role in do!estic finance is predo!inant( such as in Egypt. )n particular( the returns on invest!ents to set up rules( institutions( and enforce!ent !echanis!s can #e greater if !ar et players have an incentive to align their o'n o#"ectives 'ith the social goal of financial sta#ility. E!phasizing incentives is not to deny the i!portance of good rules( capa#le regulators( and strong enforce!ent !easures. 6or e2a!ple( safety nets to reduce syste!ic ris should !ini!ize the !oral hazard fro! sta eholders #y li!iting ris protection and #y !a ing the cost of protection sensitive to the ris ta en. Bank Supervision and Information Disclosure

Surveillance of the #an ing syste! is the responsi#ility of the C4E and co!prises on-site and off-site supervision. 8n-site inspection involves visits to the #an s to revie' their financial condition and evaluate their !anage!ent controls. 8ff-site surveillance( on the other hand( involves regular assess!ent and analysis of #an perfor!ance #ased on the calculation of screening financial ratios for the different types of #an ing institutions. The screening ratios chec such pri!ary deter!inants of financial soundness as earnings( asset 3uality( li3uidity( and capital ade3uacy. 4ased on this surveillance( the C4E*s #oard of directors are ept regularly infor!ed of develop!ents in the #an ing industry through reports prepared #y the supervisory staff. 4an supervisors are trained on #oth on-site and off-site supervision and participate in regular training progra!s. Hevertheless( the enforce!ent of prudential regulations is 'ea ened #y understaffing and unattractive co!pensation for the supervisors. 8n-site inspection used to focus on #an co!pliance 'ith an e2tensive array of credit and tariff controls. Dith the financial refor!s of the early $%%&s and the shift to prudential regulations( greater e!phasis has #een placed on assessing #an solvency and li3uidity. 4ut the fre3uency and intensity of inspection !ay not #e up to the re3uire!ents of the ne' #an ing environ!ent. At present( it ta es the C4E nearly t'o years to conduct on-site inspection of all #an s. This is infre3uent #y international standards 9$&:. Also( the C4E e2a!iners !ay lac the necessary s ills for an effective assess!ent of ris !anage!ent techni3ues in #an s and close e2a!ination of the #an s* co!pliance 'ith regulations( particularly 'ith regard to asset 3uality as the recent #an ing and li3uidity pro#le!s suggest. To ensure sound and safe #an ing practices( there is need to develop appropriate policies for recruiting and retaining a#le staff in #an e2a!ination and supervision. )n particular( #an supervisors should #e offered attractive salaries and #e trained on !odern practices to i!prove their s ill levels. 6or off-site surveillance( the #an s are re3uired to su#!it various prudential and statistical returns to the C4E*s 4an Control Eepart!ent on a !onthly #asis. These returns are analyzed #y the C4E e2a!iners on a #an -#y-#an #asis. 6or the !ost part( the returns are revie'ed !anually due to lac of co!putational facilities. A !ore efficient surveillance re3uires a co!puter !onitoring syste! for the supervisors to o#tain infor!ation and identify changes in the financial condition of #an s in a ti!ely fashion. )t 'ould facilitate 9$$:: i.: Screening financial ratios and identifying those #an s 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 ran ing #an s 9e.g. CAME,-type rating syste!:. Auto!ated and electronic reporting under offsite supervision 'ould i!prove the a#ility of the C4E to identify e!erging pro#le! #an s and to prevent failure. The C4E recently applied the CAME, rating syste! #ut it needs to e2tend this practice as only very fe' #an s 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#"ected to 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 control #an ris . )f the !aturity !i2 e2ceeds safe li!its( the C4E notifies the #an !anage!ent of this and follo's up the !atter through on-site inspection. 0o'ever( !ore effective coordination #et'een on-site and off-site supervision 'ould re3uire upgrading the infor!ation technology and staff s ills. )n this regard( infor!ation processing need to #e auto!ated through a co!puter net'or lin ing all #an ing institutions 'ith the C4E 9to o#tain and !onitor infor!ation in a ti!ely !anner: and the recruit!ent of high cali#re staff should #e e!phasized. The trained and e2perienced C4E e2a!iners should also #e retained through attractive co!pensation pac ages.The C4E also relies on #an e2a!inations conducted #y e2perienced e2ternal auditors under its o'n guidelines. The C4E re3uires each #an to appoint t'o e2ternal auditors 9'ho en"oy the confidence of C4E: to e2a!ine the #an *s accounts and prepare an annual report. The auditors should

notify the #an and C4E of any violation to #an ing 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 indicate the techni3ues used for appraising asset 3uality and !anage!ent. At this point( it is to #e !entioned that the accounting standards !ight differ a!ong auditors !a ing it difficult to the C4E to assess and co!pare #an perfor!ance cross-section 'ise and over ti!e. This is specially pronounced in the case of pu#lic sector #an s 'hich are audited #y the govern!ent*s Central Audit 8rganization 9C8A: in addition to the e2ternal auditors. 8n the !ar et transparency front( pu#lic disclosure of financial infor!ation 'as generally poor. 4efore fiscal $%%F( #an s used to pu#lish their financial state!ents only at the end of fiscal year. Mean'hile( the inco!e state!ents of so!e #an s( especially the state o'ned( 'ere e2ceedingly #rief 'ith a couple of lines on revenues and e2penditures 'hich do not sho' the a!ount of provisions. The general pu#lic had !ore fre3uent access to infor!ation only for #an s 'hich are listed on the stoc e2change. These #an s are !andated #y the capital !ar et la' 9,a' %<>$%%.: to su#!it 3uarterly state!ents on their financial position to the Capital Mar et 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 in financial disclosure 'as !uch needed. @rogress on this front 'as necessary: 9a: for the regulatory staff to !a e policy reco!!endations and address pro#le!s on sound #asis( and 9#: to i!prove corporate governance in #an s. )n response( the C4E too a decision in $%%= !andating all #an s to adopt international accounting standards 9)AS: in preparing their financial state!ents 'ith !ore fre3uent disclosure to i!prove transparency of the #an ing sector. Starting fiscal $%%F( the #an s are !andated to prepare 3uarterly state!ents on their financial position and profit>loss account and to pu#lish these in 'idely circulated ne'spapers. The end-of-year state!ent 'ould include detailed infor!ation 'hile the state!ents of the preceding three 3uarters 'ould #e #rief. Iet( efforts !ay #e needed to strengthen institutional standards and accounta#ility in the auditing profession 9$.:. Eetailed audits #ased on accurate( for'ard-loo ing assess!ent of the #an s* asset 3uality are essential for a true evaluation of financial via#ility. Also( 'hile the C4E re3uests the su#!ission of !onthly financial state!ents #y individual #an s for !onitoring the #an ing sector*s perfor!ance( !ar et transparency is so far insufficient. 6or instance( there is no pu#lished data on such i!portant infor!ation as non-perfor!ing loans( average rates of return( and ris -'eighted capitalization. -reater and !ore fre3uent pu#lic disclosure of infor!ation7under unifor! and internationally accepted accounting practices7'ould allo' effective !onitoring sche!es of #an #ehavior #y sta eholders and esta#lish !ar et discipline. Bank Compliance and Enforcement of Regulations 4an co!pliance and the enforce!ent of prudential regulations can #e chec ed #y loo ing at such financial solvency !easures as the ratio of provisions to loans. )t should #e noted( ho'ever( that provisions cover other uses( such as asset price volatility( and not "ust loans. )n the a#sence of infor!ation #rea do'n on specific provisions( it is difficult to assess the sufficiency of the level of loan provisioning in Egyptian #an s. Iet( given the high leverage ratio in the #an ing fir!( loan provisions nor!ally account for the larger part of total #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 #an s in Egypt over the period $%%$%%. There is a general up'ard trend especially in the early $%%&s 'hich represents the initial period of applying the stricter loan classification and provisioning criteria. State #an s and s!all private #an s generally used to understate the reported loan-loss provisions and overstate earnings. 6ollo'ing tighter regulations( ho'ever( the #an s 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

9state: #an s as e2cessive. Dhile consistent 'ith international practice( strict i!ple!entation of such a regulatory sche!e 'ould depress profita#ility and significantly reduce the lending activity. The specialized #an s note that their loan portfolio is distinct fro! other types of #an s 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 !ar ets served #ut they usually 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 in ter!s of co!pletion ti!e( the lending #an has to #uild up provisions even 'hen it controls a guaranteed source of repay!ent. The C4E*s point of vie' is that insofar as the pledged collateral !ay not #e easily li3uidated( the collateral*s collection value is uncertain particularly 'ith the slo' and e2pensive procedures of 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 contracts enforced is perceived. A legal infrastructure in support of #an lending 'ith appropriate legislation relating to #an ruptcy and collateral is dee!ed necessary for a 'ell-functioning #an ing syste!. )!prove!ent of ar#itration institutions in Egypt is also sought as a relatively faster alternative for dispute resolution. )t is note'orthy that in ans'er to these de!ands( the govern!ent issued in $%%% a ne' #ill 'hich 'ould sti!ulate co!!ercial life. Against this #ac ground( the specialized #an s have 'idened the scope of their operations to i!prove their perfor!ance and ta e account of the changing !ar et conditions. 6or e2a!ple( they e2pand on trade finance related to the sectoral activities of their clients( introduce lending services to non-traditional custo!ers under #roader definitions of their develop!ental tas s( and increase self dependence in fund raising through #ond issues and attractive yields on ti!e deposits 'hich are i!portant for !ediu!- and long-ter! lending. Dhile the authorities !ay vie' these develop!ents as favora#le to a !ore co!petitive syste!( this actually entails a !ove to'ards despecialization as the portfolio #ehavior of specialized #an s 'ill #e si!ilar to that of universal ones. The pu#lic sector co!!ercial #an s also have difficulties in i!ple!enting the C4E*s regulations on pro#le! loans. This ste!s fro! the high share of lending to pu#lic enterprises in their loan portfolio. 4efore the enact!ent of ,a' .&1>$%%$ 'hich reorganized the pu#lic enterprise sector into financially autono!ous co!panies cut off fro! the fiscal #udget 'ith the ai! of su#"ecting the! to co!petitive !ar et forces and privatization( !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 the population as part of the social 'elfare sche!e introduced in the early-$%/&s. The pu#lic enterprises operating under this syste! used to o#tain cheap credit fro! the state #an s #ut had difficulties servicing their de#ts5 they 'ere #orro'ers 'ith high default ris . 4ac ed #y the govern!ent( the state #an s 'ere not su#"ected to strict #an ing supervision 'ith the result that they had to #uild up su#stantial loan-loss provisions under the $%%&s refor!s. 4ecause this 'ould adversely affect their profita#ility in the shorter run( the #an s 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 the settle!ent of pu#lic enterprises inde#tedness and the ensuing i!prove!ent in 3uality of the #an s* loan portfolio. 6urther sti!ulus to the ad"ust!ent process of state #an s 'ould co!e fro! the sales proceeds of their shares in profita#le "oint-venture #an s. )t should #e noted( ho'ever( that these shares have provided the! 'ith a relia#le source of profit 'hile holding large non-perfor!ing loans in pu#lic enterprises. Aegarding private #an s( the !a"ority have #een follo'ing prudent lending policies 'ith little difficulty in acco!!odating the strengthened #an regulations. They ad"usted 'ith a reasona#le speed. )n the !eanti!e( so!e s!all private sector #an s 'hich are generally undercapitalized lag #ehind in co!plying to the regulations. Mergers #et'een such #an s and #etter !anage!ent !ay allo' the! to survive the ne' policy environ!ent( favora#le for a !ore co!petitive #an ing syste!. )n this conte2t( $< s!all regional #an s 'ere !erged in $%%1 into a single institution 9Hational 4an for Eevelop!ent:. Also( the t'o specialized real

estate #an s !erged in $%%% 9Credit 6oncier Egyptien and Ara# ,and 4an 'ere !erged as the Egypatian Ara# Aeal Estate 4an :. Ta ing the nature of their e2isting loan portfolios into account( the C4E has #een fle2i#le in the enforce!ent of the regulations on pu#lic sector co!!ercial #an s and specialized #an s. They are allo'ed a gradual adaptation to the stricter loan classification and provisioning criteria. Dhile their loan-loss provisions have increased( they are #elieved to #e still 'ell #elo' the re3uired levels so as not to depress profita#ility. Si!ilarly( the s!all private #an s are allo'ed a phase-in period. Even though deadlines have #een set for ad"ust!ent #y the different #an s( it is not o#vious ho' credi#le this can #e5 the ad"ust!ent process lac s transparency. A !easure of #an perfor!ance 'hich considers provisioning and profita#ility is the provision for loan loss ratio5 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 #an s over the period $%%$-%F. As can #e seen( the provisions ratio is significantly higher for the pu#lic sector co!!ercial #an s given a large size of non-perfor!ing loans to the state-o'ned enterprises. The lo'er ratios sho'n for the private #an s and the specialized #an s( 'ho !ainly cater to the needs of the private sector( reflect #etter asset 3uality and profita#ility in these #an s. )t should #e noted( ho'ever( that credit ris in the specialized #an s is nor!ally higher than in the private #an s as they typically lend to #usinesses involved in cyclical activities5 e.g.( agriculture and real estate. This suggests 'ea i!ple!entation of the C4E*s loan classification and provisioning criteria in the specialized #an s as one 'ould e2pect higher provision ratios7at least co!pared 'ith the private #an s7than sho'n in the figure. )nsert 6igure . here )ntroducing !ar et 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 #an s 'ith incentives for #uilding up provisions 'ithout necessarily depressing their profita#ility. At present( ta2 treat!ent of loan losses in Egypt does not appear to #e providing #an s 'ith incentives for i!proving their financial strength. E2cept for #ad de#t 9as opposed to su#standard and dou#tful de#ts: and up to $& percent of net profits( loanloss provisions are not ta2 deducti#le5 inco!e ta2 on #an #usiness is ;& percent. 4ut 'hen a loan ulti!ately proves to #e uncollecta#le and is charged off( a ta2 re#ate is allo'ed. Eue to deficiencies in ta2 ad!inistration( ho'ever( the re!itted a!ount is usually delayed for years 'ith negative i!pact on #an li3uidity. 9Charge-offs reduce provisions for loan losses( lo'er reported profits( and decrease a #an *s net 'orth5 they raise #orro'ing costs on purchased funds.: )t 'ould #e helpful to #an s if the efficiency of ta2 ad!inistration is i!proved or if provisions are ta2 deducti#le. Such !easures 'ould contri#ute to greater #an loss provisions and higher profits. That is( the a#ility of #an s to a#sor# future losses 'ould i!prove together 'ith their perfor!ance. The C4E regulatory syste! is #ased on a purely 3uantitative !ethod applied to all #an s( regardless of their size or their individual nature. Under unifor! and international audit standards( the !ain advantage of this !ethod is ensuring a certain transparency in the #an ing sector #y providing o#"ective co!parisons. 8n the other hand( it does not sufficiently ta e into account asset 3uality and !anage!ent efficiency of the #an s in light of their #usiness type and principal orientations 9$;:. This dra'#ac ris s 'ea adherence to the prudential regulations as suggested #y the Egyptian case 'ith respect to the state-o'ned and s!all private #an s. ,oan classification and provisioning rules are( in general( not strictly i!ple!ented #y these #an s. A practice 'hich is apparently encouraged #y the nondeducti#ility of loan-loss provisions for ta2ation purposes on one hand and #y understaffed 9#oth in ter!s of 3uantity and s ill levels: C4E e2a!iners on the other. The latter casts dou#t on effective enforce!ent po'ers. To i!prove the enforcea#ility of #an ing regulations( the C4E !ay find it 'orth'hile to reconsider the ho!ogeneity of the for!s of control given the diversity of #an types. Alternatively( the 3uantitative regulatory syste! !ay #e reinforced 'ith post-li#eralization #an restructuring directed to'ards universal

#an ing 9despecialization 'ith s!all #an s li3uidated or !erged for #etter portfolio diversification:. Dhile there are potential econo!ies of scale fro! universal #an ing( the greater ris s involved call for esta#lishing holding co!pany structures 'ith separately capitalized su#sidiaries to carry out such activities as securities trading and fund !anage!ent. The increasing nu!#er of #an s in Egypt 'ith holding co!pany structures suggests a trend to'ards universal #an ing 9the nu!#er increased fro! four #an s in $%%; to si2teen in .&&&:. Transparency of pu#lic policy on the envisaged structure of the #an ing syste! should #e e!phasized for accounta#ility and enforce!ent purposes. Also( in order for the C4E to properly discipline the #an ing sector( #an regulations should #e applied forcefully. 8n-site and off-site supervision should #e strengthened to send a strong signal to #an s 'hich do not follo' prudent practices and to i!prove solvency of the #an ing syste!. A tough stance should #e ta en 'hen dealing 'ith pro#le! #an s such that only those assessed to #e via#le in the longer ter! 'ould #e restructured #ut under ne' !anage!ent and o'nership5 #ad !anage!ent should not #e re'arded and corporate governance in the #an s should #e i!proved. +ust as 'ell-!anaged #an s !onitor their #orro'ers( the authorities can serve depositors #y !onitoring #an s on their #ehalf. -overn!ent regulation should go #eyond processing infor!ation and pu#lishing the results. The regulator !ust not allo' a #an to continue functioning 'hen it is insolvent5 the #an !ay #e li3uidated or !erged into another #an 9$<:. More precisely( the regulator should not refrain fro! e2ercising their regulatory right to put the insolvent #an out of #usiness. Aegulatory for#earance increases the !oral hazard incentives for #an s #ecause an operating #ut insolvent #an has al!ost nothing to lose #y ta ing on greater ris s5 if the ris y invest!ents pay off( it gets out of insolvency. The sta#ility of the #an ing industry cannot #e achieved( ho'ever( 'ithout enterprise refor!. ,oan losses are incurred through the failure of #an #orro'ers to honor their contracts #ecause of #ad policies( ineffective !anage!ent( or 'ea institutional fra!e'or s. The factors #ehind enterprise losses and inefficiencies should #e addressed #y the authorities so as to create a favora#le #usiness environ!ent. This 'ould help the C4E in the enforce!ent of #an regulations. )n this regard( i!proving the accounting and disclosure syste!s and the legal infrastructure are crucial for infor!ation gathering and enforcing de#t contracts. The availa#ility of relia#le and co!prehensive infor!ation a#out fir!s( and the a#ility of the legal syste! to enforce contracts rapidly( effectively( and transparently 'ill add to the #an ing syste!s* capacity for financial inter!ediation. Accounting standards that produce co!para#le corporate financial state!ents !a e it easier for #an s to assess the credit'orthiness of #orro'ing fir!s and to evaluate their !anage!ent. Also( the inclusion of loan covenants in de#t contracts to lo'er !oral hazard and !onitor the #orro'er*s effort and ris -ta ing #ehavior7e.g.( the option of i!!ediate loan repay!ent if cash flo' falls #elo' a certain level7necessitates 'ell-defined accounting and auditing standards( 'ith trained auditors capa#le of verifying the accounting infor!ation. Mean'hile( assessing the health of #an s re3uires relia#le infor!ation on loan classification and concentration( on the realistic valuation of collateral( and on loan-loss provisioning. ,egislation and la's are i!portant( #ut so is their enforce!ent. The legal syste! !ust allo' #an s to foreclose and collect their pro#le! de#ts in a ti!ely !anner such that the position of secured creditors is strengthened. A lengthy process for foreclosure and de#t recovery is a disincentive to #an s to charge-off delin3uent loans and li!it financial inter!ediation 9$/:. !. In"ormational #symmetries$ Incentives$ and Sa"ety %ets Turning to the role of incentives and safety nets in ensuring !ar et sta#ility( 'e first note that financial !ar ets are su#"ect to !a"or syste!ic ris s 'hich are detri!ental to the econo!y. 6or e2a!ple( a #an failure can spill over to others either directly through #alance sheet lin ages or through psychological contagion. This involves direct losses to depositors 'hich are often covered( at least partly( #y pu#lic finances 'hether through an e2plicit deposit insurance sche!e or through ad hoc co!pensation of an i!plicit

deposit protection sche!e. Under the i!plicit sche!e( a central #an !ay act as lender of last resort( the govern!ent !ay provide funds directly to trou#led #an s( or the govern!ent !ay ta e over these #an s and then guarantees that depositors 'ill receive their !oney in full. The #orro'ers fro! failed #an s also suffer as 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 has its dra'#ac s. The i!plicit safety net in the case of Egypt is no e2ception. De discuss the infor!ational pro#le!s associated 'ith different insurance sche!es to dra' conclusions on the design of incentiveco!pati#le safety nets 'hich !ini!ize !oral hazards 9$=:. 6irst( 'e note that if the authorities do not provide ade3uate supervision( #an s 'ith deposit insurance have an 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 not i!pose !ar et discipline on #an s #y 'ithdra'ing deposits 'hen they suspect that #an !anagers are engaged in ga!#ling activities. Iet( in the event of #an failure( the fiscal cost is significant and is eventually #orne #y ta2payers. To reduce the !oral hazard pro#le!s of safety nets( #an supervision should #e strengthened to ensure that #an s are not ta ing on too !uch ris . Mean'hile( the authorities should set incentive structures that align the private incentives of !ar et players 'ith the social good. 6or e2a!ple( in e2plicit insurance sche!es( charging insurance pre!iu!s that vary 'ith the ris iness of a #an *s assets can induce #an s to invest in lo'-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 !oral hazard. 8ne pro#le! 'ith ris -#ased pre!iu!s( ho'ever( is that #an regulators !ay have difficulty in accurately assessing the ris iness of a #an *s assets. The classification of #an s #y such !easures as the 4asel ris #ased capital standard solely reflects credit ris and does not ta e sufficient account of interest-rate ris . Accordingly( ris -#ased standards should #e !odified to include interest-rate ris and regulators should set guidelines to encourage #an s to !anage interest-rate ris . Second( e2plicit deposit insurance sche!es can ta e a variety of for!s 'ith regard to their ad!inistration and financing( 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 #an s is li ely( ho'ever( to achieve the insurance fund o#"ective of preserving pu#lic confidence in the #an ing industry !ore effectively. A pure pu#lic syste! entails a su#sidy to #an s 'hile a pure private one i!poses a ta2 on #an s and !ay #rea do'n( particularly in ti!es of #an ing pro#le!s 'ith high resolution costs7i.e.( "ust 'hen the syste! is !ost needed. )n contrast( a 3uasi-pu#lic syste! 'ith govern!ent financial #ac ing provides a !ore appealing cost-sharing and incentive-co!pati#le structure that can reduce !oral hazard and preserve pu#lic confidence. Third( unless the !e!#ership of #an s in e2plicit insurance sche!es is !andatory( only the 'ea er #an s 'ill participate in the sche!e 'ith adverse selection conse3uences. 6or the sche!e to #e ade3uately funded and financially via#le( the cost of insurance should #e shared a!ong all #an s. This surely entails a cross su#sidization of the 'ea er #an s out of the financially sound ones. Iet( all #an s 'ould #enefit fro! having a !ore sta#le industry 'here the li elihood 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 #an s and esta#lishing !ar et discipline. Dhatever the ris iness of #an assets is( depositors 'ill not suffer any losses if all deposits are fully guaranteed. This !ay encourage #an s to ta e on greater ris s( there#y increasing the li elihood of #an failures and financial insta#ility. Dhile a co!plete deposit insurance eli!inates the ris s of #an runs( it destroys the value of infor!ation production and !onitoring #y depositors for sound #an ing practices and financial sta#ility.

)n contrast( an e2plicit deposit insurance sche!e in 'hich depositors are paid off only up to a certain insurance li!it can induce #an s to engage in prudent ris ta ing. Under such a sche!e( large depositors 9holding accounts in e2cess of the deposit insurance li!it: 'ould have an incentive to !onitor #an #ehavior and pull out their deposits 'hen the #an ta es on too !uch ris . To prevent a significant loss of deposits and a possi#le related decline in franchise value( the #an 'ould #e !ore li ely to invest prudently. 6ifth( an a!#iguous safety net in the for! of an i!plicit deposit insurance sche!e 9'hich is #ac ed #y the govern!ent: !ay desta#ilize the #an ing syste! #y encouraging e2cessive ris ta ing and under!ining !ar et discipline. Dhile a!#iguity !ay #e i!portant to deter !oral hazard incentives( it !ay lead to regulatory for#earance in the face of #an ing pro#le!s. The regulator !ay #e reluctant to adopt transparent and clear rules for resolving #an ing 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 is ris 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 scope for a!#iguity has #een declining( ho'ever( 'ith trends to'ards greater disclosure of #an ing infor!ation 9$%:. Aegulatory for#earance can also arise fro! agency pro#le!s( 'hich occur 'hen the agent 9the regulator: does not have the sa!e incentives to !ini!ize costs to the econo!y as the principal 9the ta2payer:. Aegulators are ulti!ately agents for ta2payers 9principals: 'ho #ear the cost of any losses #y a deposit insurance sche!e. To act in the ta2payer*s interest and lo'er costs to a deposit insurance sche!e( the regulator !ust enforce prudential regulations and !ust not adopt a stance of regulatory for#earance( 'hich allo's insolvent #an s to continue to operate. 0o'ever( the regulator !ay lac ade3uate incentives to act in the 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!pose regulations under the e2isting incentive sche!e. This !ay happen 'hen the regulatory #ody is understaffed and poorly paid such that #an supervisors are prone to regulatory capture. )n this case( the supervisors serve the #an s rather than the interests of depositors and ta2payers. )n particular( an insolvent #an !ay offer attractive honoraria to supervisors to adopt a stance of regulatory for#earance( There #y aligning the #an *s incentive 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!s of 3uantity and s ill levels( and supervisors should #e handso!ely co!pensated. 6or the regulatory #ody to attract and retain 3ualified staff( trained to !aintain their pu#lic responsi#ilities 'hen carrying out their supervisory duties( co!pensation should #e co!petitive 'ith the private sector. E2e!pting #an supervisors fro! govern!ent salary scales !ay have less #udgetary cost than a #an failure 9.&:. )n Egypt( financial difficulties of individual #an s 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 a local partner faced solvency pro#le!s that led to govern!ent intervention to protect the depositors* funds. The C4E first re3uested other #an s to lend support in the for! of an interest-free loan e3uivalent to &..< percent of their deposits. Su#se3uently( the "oint venture !erged into a pu#lic sector #an ( 4an3ue Misr( follo'ing the collapse of 4CC)( supported #y a loan fro! the C4E 9.$:. The private sector in Egypt perceives the i!plicit govern!ent safety net as pri!arily a protection sche!e for depositors of pu#lic sector #an s5 it !ay not necessarily cover the deposits of all #an s. The a!#iguity of such an i!plicit deposit insurance sche!e !ay have opposing effects on the sta#ility of the #an ing industry. 8n one hand( it !ay encourage #an s to engage in e2cessive ris ta ing on anticipation that the govern!ent 'ill provide full insurance to depositors. 8n the other hand( it !ay i!pose !ar et discipline on #an s as

depositors can 'ithdra' their funds if they suspect that the #an s ta e on too !uch ris and that their deposits are not fully insured. Clearly( #an ing sta#ility is under!ined in the for!er case 'hereas it is strengthened in the latter. As the final outco!e of this a!#iguity can #e detri!ental to the econo!y if it leads to #an panics( it is i!portant to esta#lish a deposit insurance sche!e 'ith clearly defined rules and procedures. Such a sche!e 'ould serve as an efficient !echanis! for crisis !anage!ent. )t 'ould also allo' ti!ely e2it of insolvent #an s and foster healthy co!petition. To this end( the authorities approved in $%%. the legal #asis of a deposit insurance fund 'hich 'ould protect s!all depositors. The insurance fund 'ould replace the e2isting i!plicit protection for deposits of the pu#lic sector #an s 'ith an e2plicit sche!e covering the deposits of all #an s. The #an ing legislation declares the insurance fund as an independent agency 'hich is su#"ect to the supervision of the C4E. 0o'ever( the deposit insurance fund has not #een esta#lished as yet. 4an s are reluctant to contri#ute to'ards its esta#lish!ent( sho'ing preference instead to the less costly( though a!#iguous( i!plicit govern!ent safety net. )n light of the a#ove discussions( designing an incentive-#ased safety net7'here depositors !onitor #an #ehavior to ensure financial sta#ility7calls for a 3uasi-pu#lic syste! of partial insurance. Also( the !e!#ership of #an s in the insurance sche!e should #e !andatory and insurance pre!iu!s should #e ris sensitive. This 'ould introduce !ar et discipline as a ey ele!ent of the regulatory regi!e. At the sa!e ti!e( prudential regulations should #e enforced #y capa#le #an supervisors and such that the li elihood of regulatory capture or for#earance is !ini!ized. 4y not adopting a stance of regulatory for#earance( the #an regulator effectively li!its the fiscal costs associated 'ith safety nets( especially in the presence of spill over effects or 'ider syste!ic ris s.

&. Bank 'eterogeneity and (arket )iscipline: *anel Estimation The a!#iguity of an i!plicit deposit insurance sche!e raises the issue of its effectiveness in i!posing !ar et discipline. To study 'hether depositors effectively !onitor #an s in Egypt( 'e ta e a for!al loo at the evidence on asset ris and !ar et reaction to #an ing pro#le!s. The o#serva#le characteristics of #an s 'ith regard to asset ris and prudence include such financial ratios as the interest !argin 9the ratio of net interest to inco!e producing assets: and solvency7for e2a!ple( the ratio of provisions and e3uity to total assets 'hich ta es account of #oth loan provisioning and capital ade3uacy. 8n the other hand( 'e define !ar et discipline as the depositors* reaction to #an #ehavior such that they 'ithdra' their funds fro! #an s 'ith e2cessive ris ta ing. Accordingly( 'e use deposit gro'th as a !easure of !ar et discipline. )n general( given the interest paid on #an deposits( a lo' interest !argin i!plies a lo' 3uality of loan portfolio or invest!ent in a ga!#ling asset5 invest!ent in a safer asset yields higher average return and hence higher net interest. )n the !eanti!e( #an solvency necessitates sound practices of asset classification and provisioning such that the ratio of provisions and e3uity to assets is nor!ally higher in #an s engaged in e2cessive ris ta ing. Also( to the e2tent the !easures of o#serva#le asset ris or #an solvency indicate increased default ris ( the 'ithdra'al of deposits fro! ris y #an s i!pose !ar et discipline. A #an ing syste! in 'hich !ar et discipline plays an i!portant role in ensuring sound practices and sta#ility should have three !ain characteristics 9..:. 6irst( depositors should distinguish a!ong the default ris s of different #an s. Second( differences in deposit gro'th across #an s should reflect differences in #an asset ris . Third( depositors should act to li!it default ris such that #an s have incentive to strengthen their financial condition and avoid disciplinary deposit outflo's. Dith this in !ind( 'e investigate the !icroecono!ic evidence on the e2istence of !ar et discipline in t'o

steps. 6irst( 'e consider the evidence on the e2tent of cross-sectional heterogeneity in the Egyptian #an ing syste!. )n particular( 'e consider the heterogeneity in asset ris ( financial solvency and deposit flo's a!ong three different groups of #an s: pu#lic sector co!!ercial #an s( private #an s( and specialized #an s. Second( 'e test a !odel that relates deposit gro'th as a !easure of !ar et discipline to #an asset ris and solvency !easures. The !odel uses panel data on the three groups of #an s over the period $%%$ - $%%F( 'hich 'itnessed #an refor!s and restructuring to pro!ote perfor!ance and !ar et sta#ility. The financial state!ents of the different #an groups are pu#lished on annual #asis only starting fro! $%%$. Ta#le $ provides su!!ary statistics for the #an s* asset ris ( financial solvency and deposit gro'th for the $%%&s. The greater is the operating asset ratios( the !ore profita#le the #an ( ceteris pari#us. )n general( private #an s perfor!ed #etter than the other #an groups on the various !easures( including financial solvency( and attracted deposits at a higher gro'th rate. )nsert Ta#le $ here The profit !argin and the return on e3uity 'ere particularly high. The high profit !argin indicates that private #an s 'ere !ore efficient in controlling e2penses7for e2a!ple( overstaffing in pu#lic sector #an s increases the operating costs. The lo'er operating e2penses in private #an s also contri#uted to the greater return on e3uity. The return on assets 'as also higher in the private #an s. The interest !argin in private #an s 'as relatively lo' 'hich can #e e2plained( at least in part( #y a s!all loan portfolio relative to the deposit #ase. The interest !argin is a su!!ary !easure of net interest returns on inco!e producing assets. Dhile interest !argin of the private #an s is higher than the pu#lic sector co!!ercial #an s*( it is lo'er than that of the specialized #an s. The lo' interest !argin of the pu#lic co!!ercial #an s reflects nonaccrual of interest on a large volu!e of non-perfor!ing loans to state-o'ned enterprises. 8n the other hand( the higher interest !argin of the specialized #an s can #e attri#uted to o#taining lo'er cost funds through #orro'ing fro! state-o'ned financial institutions 9i.e. they incurred lo'er interest e2penses:. Ta#le $ provides so!e evidence on ho' lin s a!ong asset ris ( solvency( and !ar et discipline differ across the three #an groups. Specifically( 'hile deposit gro'th 'as higher in the private #an s( their #etter scores on the operating asset ratios and financial solvency 'ould "ustify an even greater inflo' of deposits than that realized #y the pu#lic co!!ercial #an s and the specialized #an s. )n other 'ords( depositors do not appear to penalize the state-o'ned #an s as !uch for e2cessive ris ta ing 9noting the large non-perfor!ing loans to pu#lic enterprises:. Eepositors could have acted !ore effectively to li!it the state #an s* 'ea ness through larger deposit outflo's or lo'er deposit gro'th. The lac of su#stantial evidence of !ar et discipline in the Egyptian #an ing syste! can #e e2plained #y the govern!ent*s i!plicit deposit insurance sche!e 'hich protects state #an s fro! the ris of insolvency and such that depositors have no strong incentive to penalize asset ris in those #an s. As argued a#ove( a !ore effective !onitoring of #an #ehavior #y depositors that foster healthy co!petition and !ar et sta#ility can #e achieved through a 3uasi-pu#lic syste! of partial deposit insurance in 'hich #an s !e!#ership is !andatory and the cost of protection is ris sensitive. He2t( 'e study a panel regression analysis of !ar et discipline as a reaction to asset and solvency ris . The !odel regresses deposit gro'th as a !easure of !ar et discipline on the interest !argin and the ratio of provisions and e3uity to assets as !easures of asset ris and financial solvency( respectively. To capture #an heterogeneity( 'e specify a fi2ed effect !odel and allo' #oth the intercept and slope coefficients to differ across the cross-sectional units 9.1 :. To ta e account of heteroscedastic and conte!poraneous correlation a!ong the distur#ances in this general !odel specification( 'e use the see!ingly unrelated regressions 9SUA: !ethod for panel esti!ation. The correlation !atri2 co!puted fro! the e3uation-specific residuals indicates that SUA produces a gain in efficiency over a generalized least-s3uares regression that only accounts for heteroscedastic distur#ance ter!s. Ta#le . reports the SUA esti!ation results. The coefficient esti!ates are statistically significant and vary

su#stantially across the #an groups. The results on !ar et discipline across #an s and in the #an ing syste! as a 'hole are !i2ed. 6or e2a!ple( the effect of the solvency !easure on deposit gro'th in the private #an s is of the e2pected sign 9positive: suggesting the operation of !ar et discipline 'ithin these #an s. Iet( the effect of the interest !argin on deposit gro'th in the sa!e #an s is contrary to e2pectation 9negative sign:( !a ing it difficult to conclude on the e2istence of !ar et discipline. A si!ilar argu!ent applies to the pu#lic sector co!!ercial #an s 'here the !easures of asset and solvency ris s have opposite i!pacts on deposit flo's. 8nly in specialized #an s is there una!#iguous evidence of the operation of !ar et discipline( 'hich !ay #e e2plained #y the fact that depositors of these #an s are !ainly financial institutions 'ho are !ore sophisticated than individuals 9on infor!ational grounds: in !onitoring #an #ehavior. )nsert Ta#le . here The a!#iguity on the e2istence of !ar et discipline in the Egyptian #an ing syste! can #e largely e2plained #y the a!#iguity of the govern!ent safety net for deposit insurance. Dithout su#stantial evidence of !ar et discipline( a conservative approach to our findings calls for policy !easures to enhance #an ing industry transparency and sta#ility. @recisely( it is i!portant to design incentive-co!pati#le safety nets 'hich align the private incentive of !ar et players 'ith the social goal of financial sta#ility. Safety nets should reduce the !oral hazard fro! sta eholders #y li!iting depositors protection and #y !a ing the cost of protection sensitive to the ris ta en. +. onclusions The Egyptian authorities undertoo !a"or #an ing refor!s in the $%%&s to'ards a !ore li#eral syste!. This included the strengthening of #an supervision and regulations on the #asis of internationally accepted standards to deal 'ith the ris s inherent in the ne' policy environ!ent. 4ut the #an ing industry re!ain highly concentrated and seg!ented 'ith the do!inance of pu#lic sector #an s. The on-going #an privatization progra! to level the playing field for all #an s 'ill help to i!prove !ar et co!petitiveness and efficiency. Safety of the #an ing syste! necessitates strong co!pliance 'ith prudential regulations. To i!prove the sta#ility of the #an ing industry( it is crucial to have effective enforce!ent !echanis!s of the regulations. At present( a nu!#er of factors li!it the enforcea#ility of #an regulations. 9i: The legal infrastructure does not provide appropriate support to #an lending 'ith the slo' and e2pensive procedures of the co!!ercial "udicial syste! in Egypt. 9ii: The state-o'ned #an s hold large non-perfor!ing loans in pu#lic enterprises 'hose restructuring 9under the privatization progra!: is still in progress. 9iii: Undercapitalization and !anage!ent inefficiencies of the s!all private #an s. 9iv: ,ac of ade3uate ta2 incentives for ta ing loan-loss provisions. 9v: Understaffed and inade3uately trained #an e2a!iners and supervisors. 9vi: Su#"ective assess!ent of #an asset 3uality as there is need to strengthen institutional standards and accounta#ility in the auditing profession. 9vii: )nsufficient #an ing sector transparency. 9viii: ,i!ited evidence of private !ar et discipline. )!proving the regulatory fra!e'or !ay re3uire reconsidering the ho!ogeneity of the for!s of control in light of the different types of #an s operating in Egypt. )f( ho'ever( the authorities 'elco!e #an restructuring to'ards universal #an ing and despecialization( pu#lic policy should #e transparent a#out this 'ith clearly set deadlines for accounta#ility and enforce!ent purposes. Enterprise restructuring and refor!s 'ould also ena#le the C4E to reinforce #an regulations. )n addition( strengthening #an supervision 'ould re3uire i!proving corporate governance in #an s and !anage!ent s ills. )n all cases( govern!ents should introduce ele!ents of private !ar et discipline as a !a"or co!ponent of the regulatory regi!e along 'ith good rules and strong enforce!ent !echanis!s.

End %otes $. Ezio#e and @azar#asioglu 9$%%F:. .. See 0u#and 9$%%%:. 1. See Dorld 4an 9$%%1:. ;. See US A)E( @rivatization in Egypt Juarterly Aevie'( +uly-Septe!#er $%%%. <. 4an ing regulations of the pre-refor! period !ay #e found in the C4E annual reports. /. See C4E 9$%%.:. =. See -overn!ent of Egypt 9.&&&:. F. 4usiness Monthly( August .&&&( pp. ;.-;1. %. 0ell!ann et al. 9.&&&:. $&. )n the US( for e2a!ple( on-site supervision for all #an s ta es place at least once a year and #y !ore than one regulatory agency. $$. See 0arviles y et al. 9$%F<:. Under the CAME, rating syste!( the financial condition of #an s are "udged #ased on their capital( asset 3uality( !anage!ent( earnings and li3uidity 9hence the acrony! CAME,:5 #an e2a!iners assign a nu!erical value ranging fro! $ to <( 'here $ is the #est rating( for these criteria. $.. See US A)E ( op. cit.( 8cto#er -Eece!#er $%%F. $1. See Dorld 4an 9$%%;:. $;. See Ee Car!oy 9$%%&:. $<. Dhen a #an is li3uidated or !erged into another #an ( the !anagers are usually fired and the shareholders lose their invest!ent. $/. See @olizatto 9$%%.:. $=. The discussions dra' on 4hattacharya et al. 9$%%F: and Talley and Mas 9$%%.:. $F. )n this sense( the contri#ution of financially sound #an s to an insurance sche!e is a pre!iu! for en"oying !ar et sta#ility. $%. Enoch( et al. 9$%%=:. .&. See @olizatto 9$%%.:. .$. See )M6 9$%%F:. ... See Calo!iris and @o'ell 9.&&&:.

.1. See -reene 9.&&&:. Re"erences 4hattacharya( S.( 4oot( A.( and Tha or( A. 9$%%F:( GThe Econo!ics of 4an Aegulation(G +ournal of Money( Credit and 4an ing( Kol. 1&( Ho. ;( pp. =;<-==&. 4usiness Monthly L+ournal of the A!erican Cha!#er of Co!!erce in EgyptM( August .&&&.. Calo!iris( C.( and @o'ell( A. 9.&&&:( GCan E!erging Mar et 4an Aegulators Esta#lish Credi#le EisciplineN The Case of Argentina( $%%.-$%%%(G H4EA Dor ing @aper( Ho. ==$<. Central 4an of Egypt 9$%%.:( 4an ing and Credit Eevelop!ents L)n Ara#icM. Ee Car!oy( 0. 9$%%&:( -lo#al 4an ing Strategy( 82ford: 4asil 4lac 'ell. Ezio#e ( C.( and @azar#asioglu( C. 9$%%F:( G,essons fro! Syste!ic 4an Aestructuring(G )M6 Econo!ic )ssues( Ho. $;. Enoch( C.( Stella( @.( and Oha!is( M. 9$%%=:( GTransparency and A!#iguity in Central 4an Safety Het 8pertaions(G )M6 Dor ing @aper. -overn!ent of Egypt 9.&&&:( Ministry of Econo!y and 6oreign Trade Juarterly Econo!ic Eigest( Kol. <( Ho. .( +anuary-March .&&&. -reene( D. 9.&&&:( Econo!etric Analysis( He' +ersey: @rentice-0all. 0arviles y( T.( A. ,. Sch'eitzer( +. T. 4oor!an(9$%F<:( Eyna!ics of 4an ing( )llinois: 0arlan Eavidson( )nc. 0ell!ann( T.( Murdoc ( O.( and Stiglitz( +. 9.&&&:( G,i#eralization( Moral 0azard in 4an ing( and @rudential Aegulation: Are Capital Ae3uire!ents EnoughN(G A!erican Econo!ic Aevie'( Kol. %&( Ho. $( pp. $;=-$/<. 0u#and( M. 9$%%%:( Egypt ,eading the Day: )nstitution 4uilding and Sta#ility in the 6inancial Syste!( ,ondon: Euro!oney @u#lications. )M6 9$%%F:( Egypt: 4eyond Sta#ilization( To'ard a Eyna!ic Mar et Econo!y( )M6 8ccasional @aper Ho. $/1. @olizatto( K. 9$%%.:( G@rudential Aegulation and 4an Supervision(G in Kittas( E.( ed.( 6inancial Aegulation: Changing the Aules of the -a!e( Dashington( E.C.: Dorld 4an . Talley( S.( and Mas( ). 9$%%.:( GThe Aole of Eeposit )nsurance(G in Kittas( E.( ed.( 6inancial Aegulation: Changing the Aules of the -a!e( Dashington( E.C.: Dorld 4an . US A)E( @rivatization in Egypt Juarterly Aevie'( Karious )ssues. Dorld 4an 9$%%1:( Egypt: 6inancial @olicy for Ad"ust!ent and -ro'th( Dashington( E.C.: The Dorld 4an .

Dorld 4an 9$%%;: @rivate Sector Eevelop!ent in Egypt( Dashington( E.C.: The Dorld 4an .

Contingent lia#ilities on guarantees for loans to other sectors Source: Central 4an of Egypt.

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