What is the Outlook for Investment Banking in the Gulf?

Investment banking, broadly defined as licensed non-banking securities market participants, has been one of the most dynamic elements of the GCC financial sector over the past decade.

Indeed, the origins of such institutions as independent institutions hardly extent beyond that, although admittedly the region’s sovereign wealth funds and a handful of comparable institutions operate in similar areas, some of them for decades.

The expansion of the investment banking / brokerage industry has gone hand in hand with the growth of regional stock exchanges as well the creation of a formal regulatory framework.

With the exception of the Kuwait Stock Exchange, which has been in operation since 1962, the largest regional bourses are relatively young, some of them only coming under proper regulation during the past decade.

Regulatory innovation during the past decade effectively replicated the one-time US model (Glass-Steagall Act) by establishing a separate licensing and supervision for non-banking financial market players.

Similar steps were taken in other regional countries, although for instance Kuwait is only now preparing a separate Capital Market Law and Authority as an arguable belated response to the excesses and difficulties of its investment company.

In practice, the investment industry has been a relatively amorphous group of entities, some of them full-service investment banks, others narrow niche operators.

In practice, the licensing regimes across the region have been relatively liberal, subject to the fulfillment of certain basic qualifications. However, the nature of supervision has varied from comprehensive monitoring modeled on international best practice, as in Saudi Arabia, to something at best fairly best reactive in Kuwait.

Regardless of their modus operandi, GCC investment banks have experienced a turbulent two-year period, echoing – and in some cases directly linked to – the experiences of some of the other growth industries, such as real estate.

Regional stock markets were battered by a widespread loss of confidence and the mass exodus of investors into cash starting in late 2008, following the sharp oil price correction and the collapse of Lehman Brothers.

As a result, market turnover has declined sharply and the lower brokerage volumes have translated directly into diminished commission income and a far more competitive market place with even the established players left defending their share of a shrinking pie.

Even though the markets have subsequently recovered impressively, they have tended to lag their emerging market peers and volumes have remained low by historical standards.

Some non-bank financial players have also fallen victim to regulatory violations in the face of ongoing efforts to clamp down on some of the malpractices of recent years and to foster the emergence of more transparent and efficient markets.

This remains a necessary, albeit challenging aspect of the transition away from volatile exchanges dominated by relatively uninformed retail investors towards the Western model of markets led by institutional investors.

The downturn in equity markets has in turn put a damper on the IPO pipeline which used to be an important source of fee income for investment houses.

With the sentiment still fragile and markets far below their pre-crisis levels, a recovery in this regard has been slow in coming, even if active government support and improving sentiment are now finally offering signs of a possible turnaround. Also the much awaited wave of M&A activity and debt capital issuance has to date disappointed.

Debt capital instruments have suffered from default and market stress, in spite of efforts by some regional governments to create a yield curve. Also corporate consolidation, while likely, continues to be complicated by limitations of regional company law and a relatively limited pool of suitably qualified human capital to facilitate the process.

The area of asset and wealth management has fared better, although it continues to be complicated by a limited investable universe. The stock market downturn prompted many investors to seek capital protection, which resulted in a wave of money going into cash deposits and money market instruments, all of them less lucrative for their managers than higher-yielding or more actively managed instruments. The real estate market correction further contributed to the trend.

Under the circumstances, the lack of an established bond / sukuk market was acutely felt, since it would have offered an attractive combination of relative capital protection and more predictable returns. The nrrow portfolios have in turn contributed to high levels of volatility in many asset classes.

Both further regulatory reform and product innovation are needed to enable investors to better diversify their assets and risks. Many investment banks have suffered directly from the narrow market and many of them have extensive and heavily leveraged exposures to the property market boom. Shariah-compliant institutions have faced particularly acute challenges from the lack of products, although their aversion to leverage has protected them from some of the other excesses.

Even through the severe market turmoil of recent years has left GCC investment banks facing unprecedented challenges, the experience has largely vindicated the regulatory separation between commercial and investment banking.

It has protected commercial banks from the risks associated with non-core operations and allowed a more focused regulatory approach. Nonetheless, it is clear that many of investment banks will have to reinvent themselves and the industry as a whole is like to go through a major overhaul, however gradually.

Some institutions will be closed down through regulatory action, others will see their balance sheets shrink in a more competitive market place and likely exit altogether. There is considerable potential for consolidation, partly because of the still-limited talent pool in the sector.

Some mergers may even take place across borders in reflection of the GCC common market. It is likely that GCC investment banks, much as their Western counterparts, will face tighter regulatory requirements and will have to retreat from some of riskier practices of yesteryear.

Moreover, the growing recognition of proper risk management will cause many of them to focus more narrowly and dispose of non-core assets and activities. The end result should be a sector that is more concentrated and leaner but also more resilient and in possession of greater depth in financial and human capital.

As challenging as the present situation will be, with a number of institutions, most notably in Dubai and Kuwait still struggling with large holdings of illiquid assets, the longer-term outlook for the sector remains favorable, not least because of the impressive growth potential of the regional capital markets, which in turn is fuelled by positive economic prospects more generally.

The regional capital markets will grow and deepen, and investment houses can help facilitate their increasing institutionalisation and openness to foreign investors. The debt capital markets have considerable growth potential and now enjoy the active support of regional governments.

The region is likely to experience a wave of corporate consolidation and restructuring, partly because of regional integration and growing foreign involvement.

But regional investment houses can also play a key role in creating new products for their clients and establishing an advisory culture that better positions them for the challenges of the future.

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