Build it so it doesn't break!

The Gulf's capital and financial markets are booming - there's plenty of liquidity sloshing about in the region due to the oil boom, stock markets are soaring, property prices are soaring and economies are being privitised and liberalised. Most major Western banks are now have offices either in Dubai, Doha, Bahrain or all three. Goldman Sachs has acquired a stake in the National Commercial Bank of Saudi Arabia, and Morgan Stanley has bought off The Capital Group (Saudi Arabia) to gain access to the Saudi markets. This influx of foreign firms and capital has been hastened by the ongoing 'credit crisis' in the West.

It is critical that the Gulf states manage this economic change wisely by building a sound regulatory and institutional structure. This is extremely important in the case of financial services - the crisis in the West, due in part to preventable circumstances - should make this clear. Willem Buiter, Professor at the London School of Economics, highlights the failure of the western financial model in an article in the FT - these failures include, according to Prof Buiter, myopia, opportunism, a homogeneity of outlook and zealous opposition to regulation.

It is vital that the very banks that have crippled the financial system in the West are not allowed to act in the same, irresponsible ways in the Gulf. Unfortunately, though it is perhaps too early to tell, the signs are that the Gulf states risk importing the flawed financial system of the West wholesale. The extreme competition between Dubai, Doha and Bahrain to attain the status of the region's premier financial hub only exacerbates this danger. Other than providing infrastructure, the main incentive these centres can use to attract banks is regulation - the lighter the regulation the more attractive the location becomes for a bank. In addition, if their regulatory regimes are not coordinated the prospect of regulatory arbitrage in a GCC common market or monetary union becomes all the more likely.

Importing a flawed financial model wholesale, and doing it improperly (by allowing regulatory arbitrage and other loopholes) will mean that the Gulf's financial markets will ultimately prove to be a barrier to economic progress - the financial market's role is to allocate financial resources in the most efficient way - and if this same market is systematically mis-allocating resources then the productive capacity of the Gulf will be severely diminished.

Update: An anonymous reader points out that Bahrain is the preferred choice for most financial institutions prefer Bahrain as their location in the Gulf. It is certainly true that Bahrain has historically been the pre-eminent financial hub of the Gulf region due to its relatively sophisticated regulatory structure, although it is questionable whether Bahrain still retains its pre-eminence. It would be interesting to see how financial institutions leverage differences in regulation in a common market or monetary union in the GCC.