Until the mid-twentieth century, Arabia had no formal money and banking system. To the degree that money was used, Saudis primarily used coins having a metallic content equal to their value (full-bodied coins) for storing value and limited exchange transactions in urban areas. For centuries foreign coins had served the local inhabitants' monetary needs. Development of banking was inhibited by the Quranic injunction against interest. A few banking functions existed, such as money changers (largely for pilgrims visiting Mecca), who had informal connections with international currency markets. A foreign bank was established in Jiddah in 1926, but its importance was minor. Foreign and domestic banks were formed as oil revenues began to increase. Their business consisted mostly of making short-term loans to finance imports, commercial trading, and businesses catering to pilgrims.

The government issued a silver riyal in 1927 to standardize the monetary units then in circulation. By 1950 the sharp increase in government expenditures, foreign oil company spending, and regulation of newly created private banking institutions necessitated more formal controls and policies. With United States technical assistance, in 1952 the Saudi Arabian Monetary Agency (SAMA) was created, designed to serve as the central bank within the confines of Islamic law.

The financial system has developed several layers intended to serve a number of multifaceted economic, exchange, and regulatory roles. At the apex was SAMA, which set the country's overall monetary policy. SAMA's functions also included stabilization of the value of the currency in an environment of openness with respect to exchange transactions and capital flows. The central bank used a number of monetary policy instruments for this purpose, including setting interest rates for commercial banks, which have been kept close to comparable dollar rates, the management of foreign assets, and the introduction of short- and medium-term government paper for budgetary and balance of payments purposes and to smooth fluctuations in domestic liquidity. SAMA also regulated commercial banks, exchange dealers, and money changers and has acted as the depository for all government funds; it paid out funds for purposes approved by the minister of finance and national economy.

SAMA's charter stipulated that it would conform to Islamic law. It could not be a profit-making institution and could neither pay nor receive interest. There were additional prohibitions, including one against extending credit to the government. This latter prohibition was dropped in 1955, when the government needed funds and SAMA financed about one-half of the government's debt that accrued in the late 1950s. From 1962 to 1983, the budget surplus did not require such action and all the government's debt was repaid. In 1988 SAMA was once again required to bolster government reserves, which had been sharply reduced to finance fiscal deficits, through the sale of Government Development Bonds. These bonds had varying short- and long-term maturities, with yields competitive with international interest rates. As a result of persistent government deficits, the stock of these bonds had grown to well over SR100 billion in 1991. Most of these bonds were placed with autonomous government institutions; however, close to 25 percent were purchased by domestic commercial banks.

In 1966 a major banking control law clarified and strengthened SAMA's role in regulating the banking system. Applications for bank licenses were submitted to SAMA, which submitted each application and its recommendations to the Ministry of Finance and National Economy. The Council of Ministers set conditions for granting licenses to foreign banks, however. The law also established requirements concerning reserves against deposits. Several restrictions continued to inhibit SAMA's implementation of monetary policy. It could neither extend credit to banks nor use a discount rate because these measures were forms of interest. SAMA had little flexibility in setting reserve and liquidity requirements for commercial banks. Its primary tool for expanding the credit base consisted in placing deposits in commercial banks. (OT)

By the 1980s, new regulations were introduced, based on a system of service charges instead of interest to circumvent Islamic restrictions. As of the early 1990s, banks were subject to reserve requirements. A statutory reserve requirement obliged each commercial bank to maintain a minimum of noninterest-bearing deposits with SAMA. Marginal reserve requirements applied to deposits exceeding a factor of the bank's paid-in capital and reserves. Moreover, banks had to hold additional liquid assets-- such as currency, deposits with SAMA beyond the reserve accounts, and Government Development Bonds--equal to part of their deposit liabilities. SAMA used two other instruments to manage commercial bank liquidity. The Bankers' Security Deposit Account (BSDA) was a short-term instrument with low yield, rediscountable with SAMA and transferable to other banks. In November 1991, SAMA issued the first treasury bills, which were short-term, usable for both liquidity management and government deficit financing, and designed gradually to replace the BSDAs.

Twelve private commercial banks operated in the kingdom, providing full-service banking to individuals, and to private and public enterprises. Eight of the banks were totally Saudi-owned. Four were joint ventures with foreign banks. In 1975 the government adopted a program of Saudi participation in ownership of foreign banks operating in the kingdom. In December 1982, the last of the foreign banks merged with a Saudi bank. The commercial banks operated more than 1,000 branches throughout the country and a widespread network of automated teller machines. The range of bank activities grew markedly during the 1970s and 1980s. Beyond providing credit and deposit facilities, they engaged in securities trading, investment banking, foreign exchange services, government finance, and development of a secondary government bond-treasury bill market.

For years money exchangers remained an anomaly in the Saudi banking system. They had operated for centuries in Arabia, particularly for pilgrims to Mecca. Most were family businesses, some of which had grown very large since World War II, conducting most kinds of banking activities in many areas of the country. Although licensed, the money-exchange houses remained largely unregulated. Most money exchangers operated under sound business practices; however, a series of fraudulent and speculative practices in the 1980s prompted SAMA to establish regulations for money-exchange houses. One of the larger such operations was converted to a commercial bank in 1987.

Because commercial banks favored short-term lending to established firms and individuals, the government created special credit institutions to channel funds to other sectors and groups in the economy. The Saudi Arabian Agricultural Bank was formed in 1963 to provide development financing and subsidies to the agricultural sector. The Saudi Credit Bank was formed in 1971 to provide interest-free loans to low-income Saudis who could not obtain credit from commercial banks. The Public Investment Fund was created in 1973 to help finance large public ventures. The Saudi Industrial Development Fund was established in 1974 to provide interest-free, medium- and long-term financing of up to 50 percent of the cost of a private sector project. The Real Estate Development Fund, also founded in 1974, was designed to encourage private sector residential and commercial building, partly through interest-free loans to low- and medium-income Saudis for up to 70 percent of the cost of a home.

The government budget provided almost all the funds for these specialized credit institutions and continued to increase their capital requirements until the mid-1980s, when budgetary problems necessitated cutbacks. For the most part, these funds were self- financing during the latter half of the 1980s. A significant departure from such self-financing was the government's substantial subvention to the Real Estate Development Fund in 1991 to allow a one-year moratorium on payments, which was a gift by King Fahd to his citizens.

The Saudi financial system also consisted of three autonomous government institutions, included because of their significant role in providing financing for budgetary shortfalls, deposits with SAMA, and foreign currency holdings. These included the Pension Fund, the General Organization of Social Insurance, and the Saudi Fund for Development.

For much of the 1980s, the stock exchange, created in 1983, was largely viewed by domestic investors as a vehicle for long- term investments. Since the Persian Gulf War, this situation changed markedly because the exchange has attracted investors seeking shorter-term investments. Share prices and trading volumes have grown sharply and by early 1992 had reached unprecedented levels, sparking fears of overvaluation. The official stock market index, which had remained relatively dormant in the late 1980s, and had dropped from 108.7 at the end of 1989 to 98.0 in late 1990, roughly doubled to 187.7 by the close of 1991. The value of shares traded grew from SR135 million at the end of 1990 to SR1.8 billion by the first quarter of 1992. The number of shares traded doubled from 15 million for the whole of 1989, to 29.2 million in 1991.

Three factors propelled this level of stock market activity. First, following the Persian Gulf War, confidence in the Saudi economy spurred by high oil prices and greater confidence in the regional geopolitical situation prompted domestic investors to repatriate foreign funds. Second, low international interest rates, combined with similar returns of domestic savings rates, increased the attractiveness of the stock exchange. Third, the number of companies trading on the exchange increased markedly as they attempted to boost domestic investment following several years of depressed economic conditions. Moreover, the tight government budget prompted some public enterprises to obtain capital on the domestic financial markets rather than from the state.

The Saudi stock exchange was not open to foreign investment and only shares of Saudi companies could be traded. The exception to the former rule was the right of citizens of GCC member states to purchase Sabic shares from 1984. In 1991 the Arab National Bank, partially funded by Jordanian capital, received permission to launch a stock fund, of which foreigners might purchase a portion. Despite growth in the stock market, the percentage of shares traded as a percentage of total market value of shares outstanding has been estimated as no more than 5 percent, very low by international standards. This lack of market depth resulted from the high proportion of shares owned by institutions rather than individuals and the concentration of ownership in a few hands.