LONDON, 1 January 2003 — On the face of it, news that the Saudi Ministry of Interior on the recommendation of a special ministerial committee and of the Saudi Arabian Monetary Agency (SAMA), has banned some two dozen investment companies that were operating without a license, and therefore were not regulated, and were offering unrealistic interest rates and returns, should be commended.
Until these companies are fully audited and the extent of their liabilities and assets assessed, it is not clear whether thousands of Saudi depositors stand to lose their hard-earned investments or not. Reports suggest that some SR7 billion have been collected by these unauthorized firms with some 50,000 depositors mainly in the Eastern Province affected.
News of the crackdown actually precipitated a run on these companies with depositors in Dammam and Dhahran blocking traffic in their frenzy to get their money back, which turned out to be futile.
The issue once again raises serious questions that need answering by the authorities relating to the financial licensing, regulatory, and enforcement culture in the Kingdom. It comes at a time, ironically, when the authorities have been adopting economic and financial reforms including the imminent introduction of draft insurance, stock market and capital market laws. These companies smack of the infamous “Pyramid” schemes which have plagued many countries all over the world over the years, although it could also be a case of sheer gratuitous speculation and inept investment strategies.
In the 1960s and 1970s the US, UK, and European countries had their fair share of such scandals. Later on it was the turn of East Asia and Latin America. More recently, a number of such schemes have surfaced in the “newly-liberated” Central and East European countries such as Albania, Russia, and Yugoslavia, and in Africa including Nigeria and South Africa.
In the Middle East, the most notorious example was in Egypt in the 1980s when two such investment companies, of which the prime one was Al-Rayan, collected billions of dollars from unsuspecting and perhaps naive and greedy investors. Only after the schemes collapsed and the scale of the mismanagement became clear, did the Egyptian authorities act. By then it was too late in what was clearly a failure of monitoring and regulation.
However, because Al-Rayan claimed that investments were Shariah-compliant and to a large extent cajoled potential depositors into investing because of religious injunctions against interest (riba), the Bank of Egypt (the central bank) and the Egyptian government at the time gave the expedient impression that Al-Rayan was a failure of Islamic banking and not of regulation and monitoring.
It is unfortunate that because of this Al-Rayan affair, the Egyptian authorities still remain cynical and tepid in their approach to Islamic banking. Yes they have licensed one or two banks, but this is more out of expediency to attract foreign investment.
The irony of course is that Al-Rayan was no more Islamic than BCCI. In fact, one of Al-Rayan’s partners was an Egyptian of Greek descent, who was a Christian Orthodox. The danger is that Saudi Arabia and especially Islamic banking in the Kingdom could be tarnished with a similar brush. After all the investors, some reports suggest, may also have been attracted by the “religious cover” under which these companies operated. The fact that investors actually withdrew money from the licensed commercial banks to invest in these schemes is both a reflection of the lack of investor education and the inadequate marketing of local banks, especially those offering Islamic banking products and services. As a so-called “specialist” in Islamic banking, I still receive enquiries from people across the board in the Gulf about information of Islamic banking products available in the region. Bankers privately confirm the various legal and regulatory restrictions on advertising Islamic banking products in many Gulf states.
Lack of investor education remains a universal problem and is a relative phenomenon depending on the stage of financial system development. Financial innovation, like others, is an on-going organic phenomenon. Every new piece of innovation such as Internet banking, e-banking, credit derivatives, and so on, drives the necessity for new regulation.
It is usually the alertness, the capacity, the ability, and the urgency of regulators that pre-empt major financial scandals. Unfortunately, in recent years, even the global giants such as the US and UK have been found wanting as proven by the insider trading, junk bond, and hedge fund scandals in the US, and by the mortgage insurance mis-selling and pensions scandals in the UK.
Nevertheless, in the UK, for instance, which is a much more advanced financial culture than Saudi Arabia, the government is only now making the teaching of money management and the basics of taxation compulsory in primary education. The aim of regulators everywhere is to educate investors not to invest in schemes offered by companies or institutions that are not regulated or licensed. Or if investors have any doubts about any such scheme, the regulatory authority should have a freephone hotline to advise investors of the legal status of companies operating such schemes. In the face of the IT revolution and the explosion of the Internet-based financial products, the number of dodgy investment schemes offering incredible rates of returns have undoubtedly proliferated. And regulators in the West let alone their counterparts in the emerging countries, are left reeling in many instances.
That is why, given the international nature of capital flows, and investment and finance, there should be a global approach with certain sacrosanct universal standards. It would be up to individual regulatory authorities to police, monitor and regulate these standards. Those rogue regulatory authorities which fail to do so, should then become pariah states with some sort of sanctions applied to them.
These universal standards in an era of globalization (including that of Islamic banking) would include:
* Any bank, institution, or company that takes deposits must be regulated by the central bank or its legally designated equivalent. Any violation of this basic tenet must be accompanied by strong punitive measures and full recourse in law. It must be a criminal offense to take unauthorized deposits from investors.
* States must have the appropriate catchall banking regulations and laws in place to accommodate whichever relevant type of banking, for instance conventional banking and/or Islamic banking, that may or may not be practiced in their jurisdictions.
* Only those vetted and approved by the regulatory authorities as “fit and proper” persons, should hold senior management positions in these banks, institutions and companies.
* Religious cover is no basis for sound investment operations.
* Religious leaders should be proscribed by law from endorsing faith-based and ethical investment schemes that are unlicensed, unauthorized, and unregulated.
* All banks, financial institutions, and investment companies that are licensed to take deposits or manage investors funds, must participate in a central bank-managed deposit insurance scheme.
In Saudi Arabia, it is puzzling how the authorities or indeed SAMA could ban companies from operating that are not licensed in the first place. It is like the Saudi Medical Association banning a quack from practicing medicine. The reality of course is that these should be treated as criminal violations which they ought to be in law. It took the decisive action by the Interior Ministry to put these illegal companies out of business, after most of them ignored earlier warnings by SAMA. It is not customary for illegal companies to receive warnings to stop their illegal activities. To add insult to injury, SAMA has even granted a grace period of four weeks (to Jan. 20, 2003) to these companies to submit their own audits of their financial position as a preparatory move toward merging some of these institutions to form a commercial bank. This is no basis for the granting of any banking license. The fact that those who promoted these schemes sought to break the law to set up their unlicensed operations speaks volumes. SAMA should be sending in their own liquidators to assess the true financial position of these companies. There are inherently complex considerations given that a substantial amount of the money has been invested in real estate. The companies themselves may overvalue these real estate assets thus massaging their balance sheets artificially. As such independent valuation of these assets is a necessity. Whatever assets are recouped should be firstly used to pay off depositors, then to pay off any fines.
Some economists have welcomed the SAMA move as pragmatic. But in the wider world, accommodating law breakers with kid gloves could be perceived as a sign of weakness, and could affect the reputational value of the Saudi regulator.
