Financial Intermediation and the Evolving Role of the Central Bank
Emmanuel K. Martey
The macroeconomic challenge facing Oman requires an efficient mobilization of saving and optimal financial intermediation, to ensure that the mobilized resources are so deployed as to maximize the real output of the economy. This requires an appropriately functioning institutional framework, diversified instruments for saving mobilization, an efficient financial regulatory and supervisory framework, a nondiscriminatory tax environment, and a well-functioning capital market to channel available resources into productive activities.
This section begins by reviewing developments in financial intermediation in Oman and analyzes the current status of the institutional and regulatory framework of the financial system. It also assesses the prospects for the use of indirect instruments of monetary policy and the achievement of an optimal environment for the needed financial intermediation over the medium term. It then describes the current institutional framework of financial intermediation and assesses its adequacy with respect to the policy objectives of the authorities. It goes on to describe recent monetary developments and examines the degree of financial deepening and intermediation that have been attained. The role of the Central Bank of Oman (CBO) in this process is also reviewed. The section concludes that considerable transformation of the financial system, including further deepening and improved regulatory reform, has occurred over the past two and a half decades; some areas for further reform are also highlighted.
Institutional Framework
Oman’s financial system has undergone considerable transformation over the past two and a half decades. Since the promulgation of the banking law in 1974, the institutional framework of the financial system has widened, and the CBO’s regulatory and supervisory powers have been deepened.1
Commercial Banks
Over the past two and a half decades the expansion of the banking system has been marked, even though in 1981 the authorities placed a moratorium on the licensing of new banks. During 1973–97 the number of local banks increased from two (with 65 operating offices) to seven (with 275 operating offices). Simultaneously, the number of foreign banks rose from five (with 24 operating offices) to ten (with 29 operating offices). Since 1993 the structure of the banking system has been consolidated through a number of mergers. In 1993 and 1994 three mergers of six commercial banks took place, and in June 1998 the Bank of Oman, Bahrain and Kuwait merged with the Commercial Bank of Oman. A deposit insurance scheme was established in March 1995, providing protection on net deposits of up to RO 20,000 ($52,000) per account, or 75 percent for each depositor, whichever is lower.
Following the adoption of the investment banking act in 1989, 12 commercial banks were granted licenses to engage in investment banking, of which 7 were permitted to be active in all areas specified in the regulation, 4 were licensed to operate as investment brokers and advisors, and I was authorized to undertake project finance. Also, in June 1994 five mutual funds began operations, with a combined paid-up capital of RO 38.6 million and authorized capital of RO 49.3 million.2
Oman also has two specialized banks, the Oman Housing Bank (OHB) and the Oman Development Bank (ODB). The OHB (which is 100 percent Omani-owned) provides financing mainly to low-and middle-income Omanis to build or purchase residential property. Besides its own capital, the OHB has received loans from the government and deposits from individual borrowers and insurance companies, and it has engaged in short- and medium-term borrowing. The ODB—which is 40 percent owned by the government, 40 percent by foreign entities, and 20 percent by the local public—resulted in its present organization from the 1997 merger of the Oman Development Bank with the Oman Bank for Agriculture and Fisheries (OBAF). It finances private sector industrial projects through medium- and long-term loans and equity participation and extends short and long-term loans to individuals for fanning and fishing activities.
Nonbank Financial Intermediaries
Oman also has a number of nonbank financial intermediaries, including 16 insurance companies and 7 pension funds, 5 hire-purchase and leasing companies, 70 money changers, and the Muscat Securities Market (MSM). The number of money changers increased markedly from 5 during 1975–80 to 70 by the end of 1997, of which II were licensed by the central bank to engage in both money changing and the acceptance of demand deposits.
The MSM was established in 1989 and has since made major strides in facilitating financial intermediation in Oman. The MSM’s capitalization rose from $1.1 billion, or 12 percent of GDP (with no government bonds), in 1989 to $8.7 billion, or 55 percent of GDP (including government bonds), in 1997 (Table 5.1). Stocks of banks and investment companies accounted for 59 percent of the MSM’s capitalization in 1997, industrial companies for 15 percent, services firms for 12 percent, and insurance companies for 4 percent; government bonds accounted for the remaining 10 percent. The number of shareholders rose from 50,000 to 163,000 during this period, and the MSM price index increased by more than 380 percent, mostly on account of a sharp (140 percent) increase in stock market prices in 1997. By the end of 1997 the volume of trading was more than 160 times that in 1989. In 1997 alone the volume of trading more than doubled from its 1996 level. The establishment of a “parallel” market in 1989 permitted separate daily trading of shares of newly established, unregistered companies; the volume of activity on this market rose from $0.5 million in 1989 to $136.5 million in 1997, when some 73,477 contracts were executed.
Key Indicators of the Muscat Securities Market
(In millions of dollars except where noted otherwise)
Key Indicators of the Muscat Securities Market
(In millions of dollars except where noted otherwise)
| Indicator | 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | 1995 | 1996 | 1997 | |
|---|---|---|---|---|---|---|---|---|---|---|
| Market capitalization | 1,078 | 1,369 | 1,639 | 2,016 | 2,349 | 3,019 | 3,420 | 4,235 | 8,748 | |
| of which: government bonds | … | … | … | … | … | 827 | 981 | 981 | 883 | |
| No. of shareholders (in thousands) | 50 | 52 | 58 | 59 | 100 | 110 | 126 | 127 | 163 | |
| Trading volume | 25 | … | 122 | 153 | 112 | 328 | 284 | 697 | 4,200 | |
| Foreign ownership (in percent) | … | … | … | … | … | … | 10.6 | 10.6 | 11.7 | |
| MSM price index (1989 = 100) | 100 | 105.5 | 119.9 | 113.0 | 113.7 | 146.2 | 158.1 | 199.4 | 480.6 | |
| Value of issues in the primary market | 74 | 55 | 130 | 116 | 403 | 543 | 439 | 332 | 955 | |
| of which: government bonds | — | — | 106 | 360 | 299 | 259 | 316 | 1.11 | 206 | |
| Market capitalization (in percent of GDP) | 12 | 12 | 14 | 16 | 19 | 23 | 25 | 28 | 55 | |
Key Indicators of the Muscat Securities Market
(In millions of dollars except where noted otherwise)
| Indicator | 1989 | 1990 | 1991 | 1992 | 1993 | 1994 | 1995 | 1996 | 1997 | |
|---|---|---|---|---|---|---|---|---|---|---|
| Market capitalization | 1,078 | 1,369 | 1,639 | 2,016 | 2,349 | 3,019 | 3,420 | 4,235 | 8,748 | |
| of which: government bonds | … | … | … | … | … | 827 | 981 | 981 | 883 | |
| No. of shareholders (in thousands) | 50 | 52 | 58 | 59 | 100 | 110 | 126 | 127 | 163 | |
| Trading volume | 25 | … | 122 | 153 | 112 | 328 | 284 | 697 | 4,200 | |
| Foreign ownership (in percent) | … | … | … | … | … | … | 10.6 | 10.6 | 11.7 | |
| MSM price index (1989 = 100) | 100 | 105.5 | 119.9 | 113.0 | 113.7 | 146.2 | 158.1 | 199.4 | 480.6 | |
| Value of issues in the primary market | 74 | 55 | 130 | 116 | 403 | 543 | 439 | 332 | 955 | |
| of which: government bonds | — | — | 106 | 360 | 299 | 259 | 316 | 1.11 | 206 | |
| Market capitalization (in percent of GDP) | 12 | 12 | 14 | 16 | 19 | 23 | 25 | 28 | 55 | |
The enormous surge in activity on the MSM over the past five years was the result of a number of factors, including the establishment of a central register in 1993, the opening of the market to other GCC nationals for investment in Oman, and improved network information and computer systems to provide ready access to prices and other activities relating to individual shares.3 Moreover, in 1996 investors anticipated the new corporate profit tax law, adopted the following year, which permits any company with 49 percent foreign ownership to be treated as an Omani company for tax purposes, provided at least 40 percent of the company’s shares were listed on the MSM. In 1997 the MSM experienced an unprecedented boom, partly fueled by a sharp rise in credit to the private sector.
Financial Instruments
The CBO has been issuing treasury bills with a maturity of 90 days at biweekly auctions since 1987; these bills have been purchased mainly by local commercial banks and have constituted the principal instrument for liquidity management by banks. The CBO also issued treasury bills with a maturity of less than 90 days to create short-term instruments of liquidity management, but these were not well received by the financial markets. There is no secondary market for treasury bills, but the central bank stands ready to rediscount them.
The issuance of government bonds began in 1991 and has been directed at both the local market and foreign residents. Currently there exist bonds of five different maturities—two, three, four, five, and seven years—with coupon rates ranging from 7.5 percent to 8.5 percent a year. Pension funds hold substantial amounts of these bonds. Although the bonds are traded on the local securities market, their interest rates are initially administratively determined by the issuing committee at the CBO. The CBO also issues seven-day certificates of deposit to commercial banks.
The above analysis indicates that significant progress has been made in recent years in deepening the financial system, but room for further improvement remains. For instance, the development of bearer bonds with simplified procedures for liquidation could be encouraged, and certificates of deposit could be better tailored to local needs to elicit greater public interest. The potential for easy asset liquidation that secondary markets for these instruments would provide could contribute to the mobilization of saving. Furthermore, increasing the role of the private sector, particularly of Omanis. in the economy over the medium term, as envisaged by the authorities, will most likely require a larger role for nonbank financial intermediaries with respect to activities not suited to the commercial banks’ portfolios. The capital base of the existing nonbank financial intermediaries is, however, relatively low and needs to be increased, and the efficiency of their operations strengthened. In this respect, the recent merger of the ODB and the OBAF is an important step toward enhancing the financial viability of non-bank financial intermediaries.
Although the financial system was further strengthened with the establishment of the MSM in 1989, the legal constraints on foreign ownership of Omani assets and discriminatory tax provisions limit the realization of potential private capital inflows. The removal of restrictions on GCC investment in Oman in 1992 contributed importantly to the increase in capitalization of the MSM, from 12 percent of GDP in 1990 to 55 percent in 1997. However, the continued low foreign participation in the ownership of MSM assets needs to be addressed; foreign ownership, mostly by GCC nationals, amounted to only II.7 percent of MSM market capitalization in 1997.
Monetary Developments and Features of Financial Intermediation
Overall monetary and credit developments over the 25 years to 1997 reflected primarily the accelerating pace of monetization of the economy and the growing demand for credit by the private sector, in line with expanding domestic private sector activity. The public sector had a minimal impact on the process of monetization, since the operations of the government and public enterprises were primarily funded by their own resources and through transfers from the government. More important, because the government maintained and managed its own foreign assets, independent of the central bank, only a small portion of its foreign assets impinged on the foreign assets position of the banking system.
During 1972–97 broad money grew at an annual average rate of 17 percent; it expanded most rapidly—at an annual average rate of nearly 28 percent—during the 13 years through 1985 (Figure 5.1). As the monetization process ebbed by the mid 1980s, the growth rate of broad money decelerated markedly; in the period 1986—97 broad money grew at an annual average rate of only 7 percent, below the average rate of growth of nominal GDP. During 1972–97 credit to the private sector grew at an annual average rate of 32 percent; it increased at an annual average rate of 54 percent on its own base during 1973–85 and at an average rate of 10 percent during 1986–97. As the government continuously maintained a net creditor position with the commercial banks—peaking at RO 327 million in December 1991—the intermediation was primarily in favor of the private sector. The ratio of credit to the private sector to total domestic credit rose from an average of 73 percent in 1972–80 to over 90 percent in 1994–97.
Selected Monetary Indicators
Sources: Data provided by the Omani authorities; IMF, International Financial Statistics, various issues.1 Defined as GDP divided by broad money.2 Multiplier defined in terms of broad money.3 Multiplier defined in terms of narrow money.Selected Monetary Indicators
Sources: Data provided by the Omani authorities; IMF, International Financial Statistics, various issues.1 Defined as GDP divided by broad money.2 Multiplier defined in terms of broad money.3 Multiplier defined in terms of narrow money.Selected Monetary Indicators
Sources: Data provided by the Omani authorities; IMF, International Financial Statistics, various issues.1 Defined as GDP divided by broad money.2 Multiplier defined in terms of broad money.3 Multiplier defined in terms of narrow money.During the second half of the 1970s and more recently during 1994–97, the commercial banks resorted to external resources to finance some domestic lending operations, while maintaining foreign assets in excess of foreign liabilities. In general, given Oman’s open exchange and payments system and fixed exchange rate regime, the central bank stood ready to provide foreign exchange to the commercial banks, and variations in the foreign assets of the monetary authorities reflected to a great extent the relative demand pressures in the economy.
Financial Deepening
The financial system that has evolved over the past two decades has had important effects on financial intermediation and the composition of private sector holdings of financial assets. Moreover, the extent to which the private sector has sought protection from financial risk through the holding of foreign currency-denominated assets has declined.
Over the period 1972–97 the main indicators pointing to financial deepening included the decline in the relative importance of currency and the increased use of the banking system:
The ratio of currency outside banks to GDP fell from 8.7 percent in 1972 to 4 percent in 1997, reflecting increased use of the banking system, as the number of commercial bank branches more than tripled, to over 300, during 1973–97 and confidence in the banking system solidified. Concurrently, the ratio of private sector bank deposits to GDP rose from 9.9 percent in 1974 to 29.8 percent in 1997, mostly through an increase in quasi money.4
Financial deepening was also reflected in the behavior of the ratio of currency to demand deposits. After falling steadily during 1972–75, the ratio of currency outside banks to demand deposits with commercial banks remained at around 110 percent during 1975–95, except for 1979—80 when the surge of world oil prices appeared to have created a temporary currency glut, and the ratio rose to more than 130 percent. (Table 5.2 shows this ratio for various subperiods from 1972 to 1997.) In 1996 and 1997, however, the ratio declined significantly, from a level above 100 percent to about 85 percent, reflecting mainly the impact of the expansion of credit to the private sector.
Although the money multiplier (with respect to broad money) fell steadily from 1972 through 1982, the subsequent financial deepening was reflected in a rise of the multiplier from 2.2 in 1982 to 5.8 in 1997, as the expansion in quasi money accelerated the growth in broad money, while the deceleration in the growth of currency in circulation tempered the rate of growth of reserve money. This development was broadly in line with developments in other Middle Eastern countries(Figure 5.1).5
Financial Deepening
(In percent)1
Data are annual averages.
Financial Deepening
(In percent)1
| Ratio | 1972–80 | 1981–85 | 1986–89 | 1990–93 | 1994–97 |
|---|---|---|---|---|---|
| Currency outside banks to broad money | 30.2 | 21.6 | 18.6 | 17.8 | 14.8 |
| Currency outside banks to demand deposits | 136.0 | 110.0 | 119.0 | 113.0 | 94.0 |
| Private sector bank deposits to GDP | 14.8 | 17.6 | 23.5 | 22.3 | 25.2 |
| Quasi money to GDP | 11.3 | 13.3 | 19.0 | 18.0 | 20.6 |
Data are annual averages.
Financial Deepening
(In percent)1
| Ratio | 1972–80 | 1981–85 | 1986–89 | 1990–93 | 1994–97 |
|---|---|---|---|---|---|
| Currency outside banks to broad money | 30.2 | 21.6 | 18.6 | 17.8 | 14.8 |
| Currency outside banks to demand deposits | 136.0 | 110.0 | 119.0 | 113.0 | 94.0 |
| Private sector bank deposits to GDP | 14.8 | 17.6 | 23.5 | 22.3 | 25.2 |
| Quasi money to GDP | 11.3 | 13.3 | 19.0 | 18.0 | 20.6 |
Data are annual averages.
The decade and a half through 1997 witnessed a significant increase in financial saving (measured as the ratio of quasi money to GDP) in the banking system. During 1973–89 the rate of growth in quasi money (including foreign currency deposits) outpaced the rate of expansion of the economy (Table 5.2 and Figure 5.1). Over the decade ending in 1996. however, this ratio flattened out at around 20 percent of GDP. In 1997 the ratio of quasi money to GDP grew substantially, to almost 25 percent, on account of strong growth in time and savings deposits driven by an increase in credit to the private sector.
Over the period 1974–97 the commercial banks relied to varying degrees on domestic and external resources in financing advances. During 1974–80 the commercial banks to some extent used external resources to complement domestic deposits to finance local lending operations: the ratio of bank advances to deposits ranged between 86 percent and 217 percent, averaging 108 percent. (Table 5.3 presents averages in this ratio for various subperiods since 1972.) However, following the oil price peak of 1981, the banks began to rely increasingly on domestic deposits, and since 1986 the ratio of advances to deposits has fluctuated around 100 percent.
Selected Commercial Banking Indicators
(In percent)1
Data are annual averages.
Data are for 1975–80.
Selected Commercial Banking Indicators
(In percent)1
| Ratio | 1972–80 | 1981–85 | 1986–89 | 1990–93 | 1994–97 |
|---|---|---|---|---|---|
| Total advances to total deposits | 108.0 | 76.5 | 91.4 | 97.1 | 106.0 |
| Foreign assets to foreign liabilities | 142.9 | 263.5 | 227.4 | 503.7 | 213.5 |
| Private sector credit to total gross credit | 72.6 | 97.7 | 94.2 | 88.9 | 92.2 |
| Foreign currency deposits to total deposits | 8.72 | 21.9 | 17.5 | 13.9 | 13.5 |
Data are annual averages.
Data are for 1975–80.
Selected Commercial Banking Indicators
(In percent)1
| Ratio | 1972–80 | 1981–85 | 1986–89 | 1990–93 | 1994–97 |
|---|---|---|---|---|---|
| Total advances to total deposits | 108.0 | 76.5 | 91.4 | 97.1 | 106.0 |
| Foreign assets to foreign liabilities | 142.9 | 263.5 | 227.4 | 503.7 | 213.5 |
| Private sector credit to total gross credit | 72.6 | 97.7 | 94.2 | 88.9 | 92.2 |
| Foreign currency deposits to total deposits | 8.72 | 21.9 | 17.5 | 13.9 | 13.5 |
Data are annual averages.
Data are for 1975–80.
Moreover, with increased confidence in the domestic economy, the commercial banks strengthened markedly their foreign assets position. The ratio of banks’ foreign assets to their foreign liabilities rose sharply, from 32 percent in 1978 to 671 percent in 1991, before falling to 133 percent in 1997.
Also, residents’ foreign currency deposits with the commercial banks became increasingly less vital to the banks’ lending operations, as increased confidence in domestic assets led to a substitution out of foreign currency deposits into time and savings deposits denominated in rials Omani. The ratio of foreign currency deposits (excluding interbank deposits) to total deposits of banks fell from 29.4 percent in 1975 to about 13.5 percent in 1997.
Interest Rate Spreads
After 1980, when domestic resources fully funded the banks’ domestic lending operations, the spread between domestic (rial Omani) loan and deposit interest rates remained virtually constant at about 1.4 percentage points. With a slight increase in the loan-deposit ratio after 1990, the impact of interest rates on foreign funds began to be felt, and consequently the interest spread rose to over 5 percentage points by 1993 (Table 5.4). The spread between the rial Omani time deposit rate and the six-month London interbank offered rate (LIBOR) on deposits turned negative during 1994 and early 1995, as the LIBOR rose more than did the Omani deposit rate, which adjusted only with a lag to developments in international financial markets. (This outcome also partly reflected the practice of reporting averages of interest rates across different maturities.)
Interest Rate Spreads
(In percentage points)
Six-month London interbank offered rate on U.S. dollar deposits.
Interest Rate Spreads
(In percentage points)
| Year and Quarter | Rial Omani Lending Rate over LIBOR.1 | Rial Omani Lending Rate over Deposit Rate | Rial Omani Time Deposit Rate over LIBOR 1 | Rial Omani Time Deposit Rate over Total Deposit Rate | |
|---|---|---|---|---|---|
| 1991 | |||||
| Ql | 2.720 | 4.190 | 0.991 | 2.461 | |
| Q2 | 3.304 | 4.380 | 1.245 | 2.321 | |
| Q3 | 3.466 | 4.358 | 1.257 | 2.149 | |
| Q4 | 4.465 | 4.554 | 2.025 | 2.114 | |
| 1992 | |||||
| Ql | 5.003 | 4.919 | 2.026 | 1.942 | |
| Q2 | 5.199 | 4.978 | 2.196 | 1.975 | |
| Q3 | 6.068 | 5.134 | 2.955 | 2.021 | |
| Q4 | 5.848 | 5.030 | 2,899 | 2.081 | |
| 1993 | |||||
| Ql | 5.524 | 4.928 | 2.442 | 1.846 | |
| Q2 | 5.689 | 5.393 | 2.035 | 1.739 | |
| Q3 | 5.689 | 5.832 | 1.338 | 1.481 | |
| Q4 | 4.968 | 5.542 | 0.646 | 1.220 | |
| 1994 | |||||
| Ql | 4.380 | 5.444 | −0.086 | 0.978 | |
| Q2 | 3.737 | 5.972 | −1.229 | 1.006 | |
| Q3 | 2.889 | 5.555 | −1.770 | 0.896 | |
| Q4 | 2.246 | 5.595 | −1.985 | 1.364 | |
| 1995 | |||||
| Ql | 2.850 | 5.993 | −1.124 | 2.019 | |
| Q2 | 2.909 | 5.288 | −0.333 | 2.046 | |
| Q3 | 3.342 | 5.357 | 0,284 | 2.299 | |
| Q4 | 3.626 | 5.419 | 0.782 | 2.575 | |
| 1996 | |||||
| Ql | 4.012 | 5.650 | 0.868 | 2.506 | |
| Q2 | 3.615 | 5.660 | 0.602 | 2.647 | |
| Q3 | 3.673 | 5.554 | 0.789 | 2.670 | |
| Q4 | 3.623 | 5.151 | 1.242 | 2.770 | |
| 1997 | |||||
| Ql | 3.483 | 5.336 | 0.707 | 2.560 | |
| Q2 | 3.186 | 5.315 | 0.471 | 2.600 | |
| Q3 | 3.245 | 4.925 | 0.817 | 2.497 | |
Six-month London interbank offered rate on U.S. dollar deposits.
Interest Rate Spreads
(In percentage points)
| Year and Quarter | Rial Omani Lending Rate over LIBOR.1 | Rial Omani Lending Rate over Deposit Rate | Rial Omani Time Deposit Rate over LIBOR 1 | Rial Omani Time Deposit Rate over Total Deposit Rate | |
|---|---|---|---|---|---|
| 1991 | |||||
| Ql | 2.720 | 4.190 | 0.991 | 2.461 | |
| Q2 | 3.304 | 4.380 | 1.245 | 2.321 | |
| Q3 | 3.466 | 4.358 | 1.257 | 2.149 | |
| Q4 | 4.465 | 4.554 | 2.025 | 2.114 | |
| 1992 | |||||
| Ql | 5.003 | 4.919 | 2.026 | 1.942 | |
| Q2 | 5.199 | 4.978 | 2.196 | 1.975 | |
| Q3 | 6.068 | 5.134 | 2.955 | 2.021 | |
| Q4 | 5.848 | 5.030 | 2,899 | 2.081 | |
| 1993 | |||||
| Ql | 5.524 | 4.928 | 2.442 | 1.846 | |
| Q2 | 5.689 | 5.393 | 2.035 | 1.739 | |
| Q3 | 5.689 | 5.832 | 1.338 | 1.481 | |
| Q4 | 4.968 | 5.542 | 0.646 | 1.220 | |
| 1994 | |||||
| Ql | 4.380 | 5.444 | −0.086 | 0.978 | |
| Q2 | 3.737 | 5.972 | −1.229 | 1.006 | |
| Q3 | 2.889 | 5.555 | −1.770 | 0.896 | |
| Q4 | 2.246 | 5.595 | −1.985 | 1.364 | |
| 1995 | |||||
| Ql | 2.850 | 5.993 | −1.124 | 2.019 | |
| Q2 | 2.909 | 5.288 | −0.333 | 2.046 | |
| Q3 | 3.342 | 5.357 | 0,284 | 2.299 | |
| Q4 | 3.626 | 5.419 | 0.782 | 2.575 | |
| 1996 | |||||
| Ql | 4.012 | 5.650 | 0.868 | 2.506 | |
| Q2 | 3.615 | 5.660 | 0.602 | 2.647 | |
| Q3 | 3.673 | 5.554 | 0.789 | 2.670 | |
| Q4 | 3.623 | 5.151 | 1.242 | 2.770 | |
| 1997 | |||||
| Ql | 3.483 | 5.336 | 0.707 | 2.560 | |
| Q2 | 3.186 | 5.315 | 0.471 | 2.600 | |
| Q3 | 3.245 | 4.925 | 0.817 | 2.497 | |
Six-month London interbank offered rate on U.S. dollar deposits.
Trends in interest rate spreads over 1994—96 can be explained as follows. As government bond yields rose, the diversion of resources to the bond market tightened the availability of local resources and raised the cost of borrowing locally in rials Omani. However, because the rial Omani lending rate rose less than did the six-month LIBOR, the spread between the two rates declined. Meanwhile, because the local market was not sufficiently competitive and. moreover, the use of lotteries distorts the determination of deposit interest rates,6 the rial Omani deposit rate did not rise pari passu, and hence the spread between the rial Omani lending and rial Omani deposit rates widened.
Central Bank’s Role in Financial Sector Development and Intermediation
The fact that Oman is a small, open economy with a fixed exchange rate and a liberal trade and payments system severely limits the independence of monetary policy (see also Section VI on this issue). Notwithstanding its limited scope for interest rate policy, the central bank’s efforts in the areas of institution building, effective legal and regulatory initiatives, and the appropriate design of indirect instruments of monetary policy can stimulate both domestic saving and foreign capital inflows and facilitate needed intermediation into productive investments.
Institutional Framework
As noted at the beginning of this section, since 1981 the CBO has been enforcing a moratorium on the licensing of new banks, in an effort to consolidate the existing financial system. Also, since within Oman the availability of financial services varies substantially by region, the CBO’s licensing policy for new branches of commercial banks distinguishes between the capital city and the rest of the country, in an effort to widen access to banking services. The policy limits to four the number of branches that each bank is allowed to open in the governorate of Muscat. To the extent that banks wish to open more branches in the capital district, they are required to open offices in unbanked regions of the country.7
Prudential Regulation and Supervision
The CBO’s statutory requirements have been periodically reviewed and updated in light of changing circumstances. The most important regulations enforced by the CBO include those relating to capital adequacy ratios, loan-deposit ratios, accounting standards, foreign currency exposure limits, and credit concentration rules. Adherence to Basle risk-weighted capital adequacy ratios has been mandatory since the end of 1992. In 1995 the central bank mandated that banks achieve a minimum risk-based capital adequacy ratio of 12 percent by 1998. A maximum loan-deposit ratio applicable to commercial banks has been set at 75 percent net of discounted bills, and 85 percent including discounted bills, to encourage the development of local money markets. Since 1981 the CBO has also imposed a limit on the foreign exchange exposure of individual banks, which should not exceed 40 percent of capital and reserves (excluding provisions). The credit concentration rule requires that direct and contingent credit to a single borrower not exceed 15 percent of a bank’s net worth.8
Prudential standards were considerably strengthened following the collapse of the Bank of Credit and Commerce International (BCCI) in July 1991, which resulted in losses to domestic depositors of the local BCCI branch and to the National Bank of Oman (NBO), which had sizable deposits with the BCCI head office in London.9 In April 1992 locally incorporated joint-venture banks were prohibited from maintaining foreign currency balances exceeding 20 percent of their net worth (excluding provisions) with either their principal shareholders or the shareholders’ branches or affiliates abroad, or exceeding 60 percent of net worth for these three categories taken together. In May 1992 the branches of foreign banks were subjected to the same limits regarding foreign currency balances with either their head office and own branches abroad, or head office affiliates abroad. Previously the aggregate limit had been 100 percent for both types of banks.
The CBO also exercised its legal powers to examine the accounts, records, and other affairs of any bank and to take necessary actions. Since 1997 the CBO has been conducting on- and offsite inspections of banks and has been operating a Bank Off-Site Surveillance (BOSS) unit as an “early warning system” to monitor individual banks and the banking system as a whole for effective supervision.10 Credit records compiled by the BOSS also serve as an online credit information source for commercial banks.
As a result of the CBO’s efforts, Oman’s banking system appears, based on key financial indicators, to be sound. By the end of 1997—one year ahead of the deadline—all commercial banks were observing the capital adequacy ratio of 12 percent. The profitability of the commercial banks, measured in terms of net profits after provisions and taxes, improved further by 36 percent, to RO 48.3 million in 1996, and a record increase was expected for 1997.
Framework of Monetary Policy
Oman’s current instruments of monetary policy include reserve requirements, maximum loan-deposit ratios, rediscounting of treasury bills and commercial paper (exchange and promissory notes), and currency swaps (introduced in 1980).
A minimum reserve requirement of 5 percent on all noninterbank deposits has been in existence since 1978.11 Under the swap facility, the central bank provides overnight and three-month rial Omani facilities to the commercial banks in exchange for dollars. A quantitative ceiling was instituted in 1994. limiting consumer loans provided by banks to 25 percent of their private sector credit.
Until 1993 the central bank enforced interest rate ceilings on commercial bank rial Omani deposits and loans. In October of that year the central bank eliminated the ceiling on time and savings deposit rates and lowered the loan rate ceiling to 10.75 percent from 11.25 percent: interest rates are not paid on demand deposits. In June 1994 lending rates were deregulated, except for rates on consumer loans in amounts of RO 9,000 or less; a ceiling of 12 percent applied to consumer loans with maturities of up to one year, and a rate of 13 percent for maturities of two years or more.12
Prospects for Transition to Indirect Instruments
Oman’s central bank currently relies mainly on direct monetary policy instruments. For the purpose of promoting competition and efficiency in financial intermediation, effectively regulating short-term liquidity, and smoothing out volatility arising from exogenous shocks, the financial system could benefit from moving to more market-based, indirect instruments of monetary control, in particular open-market operations. Here we assess the adequacy of the existing financial infrastructure for supporting the effective use of indirect instruments of monetary policy, based on the three-stage concept of reform suggested by sSundararajan (1996). This entails institutional reforms initially, followed by the establishment of a legal framework and finally a move to indirect instruments.
The 1970s and 1980s witnessed the implementation of an institutional and legal framework appropriate for the establishment of a sound banking system. Measures included promulgation of the Banking Law of 1974, delineation of the minimum size of and procedures governing the capitalization and licensing of commercial banks, and regulations governing loans, deposits, interest rates, and management of commercial banks. These were complemented by the introduction of new financial instruments—treasury bills in June 1987 and government development bonds in August 1991—and the establishment of the stock exchange in 1989. The early 1990s witnessed improvements in the legal framework, including the development of a well-functioning prudential supervision system, particularly following the BCCI crisis, and implementation of broad steps toward liberalizing domestic interest rates. A deposit insurance scheme was also introduced, which should serve to allay the fears of depositors regarding any adverse consequences of banking system contagion.
Thus, from an institutional and legal point of view, the ground for the third stage of financial reform, namely, the adoption of indirect instruments of monetary policy, seems to be prepared. In order to effectively implement such instruments, however, the array of financial instruments would need to be widened further, bond yields would have to be determined by market forces, and secondary markets in government bonds would have to be encouraged.
Challenges for the Medium Term
Several basic challenges now confront the financial system. One is to reinforce the existing institutional environment in order to facilitate the mobilization of saving. A second is to develop the intermediation process further so that both domestic and foreign saving can be efficiently translated into domestic investment. A third is to delineate interest rate and other policies that will effectively promote intermediation by equilibrating saving and investment.
Saving mobilization: This section’s review of the existing framework for saving mobilization indicates that this framework could be strengthened through widening the existing system and creating a more competitive environment. This would improve the efficiency of operations by encouraging the consolidation of existing institutions to raise their capita) base; attracting foreign institutions with the latest technology for resource mobilization; broadening the available instruments for saving mobilization; and allowing the adoption of indirect monetary policy instruments to effectively smooth out liquidity fluctuations and respond to exogenous shocks.
interest rate spreads and financial flows: Given Oman’s fixed exchange rate regime and liberal external payments system, a key role of the CBO consists of removing distortionary interest rate spreads that militate against saving mobilization and foreign capital inflows. In this connection it is important to note that the spread between the rial Omani lending and deposit rates has been on a declining trend since 1994. Moreover, the spread of the rial Omani deposit rate over LIBOR, which had been negative, has been increasing since mid-1995, thus providing an important stimulus for domestic saving and for the inflow of foreign capital. The CBO should also review the lottery system currently used by banks to attract deposits, which may distort the transparency of the interest rate structure and reduce effective deposit rates.
References
Dodsworth, J.R., M.A. El-Erian, and D. Hammann, 1987, “Foreign Currency Deposits in Developing Countries—Origins and Economic Implications,” IMF Working Paper 87/12 (Washington: International Monetary Fund).
Downes, Patrick, and Reza Vaez-Zaeh, editors, 1991, The Evolving Role of Central Banks (Washington: International Monetary Fund).
Fischer, S., and R.C. Merton, 1984, “Macroeconomics and Finance: The Role of the Stock Exchange,” in Essays on Macroeconomic Implications of Financial and Labor Markets and Political Process, ed. by Karl Brunner and Allan H. Meltzer, Carnegie-Rochester Conference Series on Public Policy 21 (New York and Amsterdam: North-Holland).
Fry, M., 1988, Money, Interest and Banking in Economic Development (Baltimore: Johns Hopkins Press).
International Monetary Fund, 1983, Interest Rate Policy in Developing Countries, IMF Occasional Paper 67 (Washington: International Monetary Fund).
Khan, Mohsin S., and V. Sundararajan, 1991, “Financial Sector Reforms and Monetary Policy,” IMF Working Paper 91/129 (Washington: International Monetary Fund).
McKinnon, Ronald, 1973, Money and Capital in Economic Development (Washington: Brookings Institution).
Sundararajan, V., 1996, “The Role of Prudential Supervision and Financial Restructuring of Banks During Transition to Indirect Instruments of Monetary Control,” IMF Working Paper 96/128 (Washington: International Monetary Fund).
The CBO was established by royal decree in December 1974, replacing the Oman Currency Board effective April 1975.
The five mutual funds are the Oryx Fund, the Muscat Index Fund, the Majun Investment Account, the Muscat International Guaranteed Fund, and the NBO-Capital Guaranteed Fund.
The MSM has also established a reciprocal listing arrangement with the Bahrain stock exchange.
In 1997 this ratio grew significantly, by 6 percentage points, reflecting the impact of the strong increase in private sector credit.
For this purpose, the Middle East is defined as comprising Bahrain, Egypt, the Islamic Republic of Iran, Iraq, Jordan. Kuwait, Lebanon, Libya, Oman, Qatar, Saudi Arabia, the Syrian Arab Republic, and the United Arab Emirates.
Oman’s banks hold lotteries to attract deposits. This system tends to suppress the return on deposits, since depositors are willing to accept lower returns on their deposits in anticipation of prospective lottery prizes.
As per circular BM 748, issued on January 8, 1995. by the CBO.
This credit limit does not apply to loans secured by cash collateral, by collateral authorized by the CBO, or by guarantee from another bank or the government or its agencies. Insider lending to senior bank management is limited to 10 percent individually and 35 percent in the aggregate.
In February 1992 the CBO took control of BCCI Oman, arranged for its sale, and provided support to enable BCCI Oman to fully reimburse all its depositors and creditors according to the amounts owed at the bank’s closure on July 5, 1991. The NBO was recapitalized and became 100 percent Omani owned. In January 1994 the government sold the 20 percent share in NBO that it had acquired at the lime of the NBO recapitalization. There were no systemic effects.
Until December 1995, the IMF provided technical assistance to Oman in the area of bank supervision. The assistance contribuled to the establishment of the BOSS unit, intended to enable The CBO to monitor banks individually and the banking system as a whole for effective supervision.
No liquidity ratio requirement is mandated.
The motivation for the use of these ceilings on interest rates stems more from socioeconomic (assistance to recently married couples, etc.) than from monetary policy considerations. The ruling rates of 12 to 13 percent allow sufficient room for banks to price the credit risk involved in individual cases.
