Two bull markets and a bear market within the space of three weeks: that very much sums up the state of the UAE stock market. Volatility is a positive characteristic for any worthwhile market — but this is not volatility, it’s madness.

The regulators say they are seized of the issue and have promised tough action. Even while conceding that it is an encouraging response, a question that has neither been asked nor answered is ‘action against what?’

If the market can be criticised for behaving like it has done, the supervisory approach has also been somewhat ad hoc. When trouble broke over the Arabtec issue, the regulators had taken the position that there was nothing amiss and the company as well as its key functionaries had followed the rule book with regard to certain transactions and developments, which the market could only view as suspicious.

When the clamour became stronger, the regulators joined in and hardened the posturing. The two approaches do not appear to complement each other, to say the least.

The contradictions are quite inherent to the local market and it is no surprise that the approaches have likewise shown tendencies of inconsistencies. The basic problem with the UAE market that it lacks the spread and depth for the kind of liquidity that it enjoys.

It is a classic case of too much liquidity chasing too few stocks; liquid stocks at that. An obvious result of the mismatch is stock inflation, which happens to be the most fundamental flaw with the market.

This quite explains why some of the stocks had been trading at ridiculous price-earning ratios, which is good for driving up the bulls in the short run, but is not sustainable in the long. So when trouble starts, it comes crashing down and no amount of propping up can save the situation.

The most important task for regulators, therefore, is to control easy liquidity in the market, as long as there are no effective channels to absorb. In ensuring this liquidity, banks have played a key part. This is where regulators face a real challenge if they intend to take their posturing to its logical conclusion.

The banks are said to be so lax in their approach that even business loans provided to companies are ending up in the stock market, not to mention personal loan customers over-leveraging their finances, jeopardising not only their financial future, but also threatening the stability of the banking sector.

This was the dangerous concoction that brewed trouble in the 2008 debacle. The major difference perhaps was that the lead wrecker was the property market, with the stock market being a victim.

The roles may have reversed this time, but the fault line runs along similar paths.

The regulators have to take a close look at margin lending in this market, which has been suffering the consequences of hot money flows. With liquidity traditionally remaining high, the market is already hyperactive and more money means more trouble.

New avenues have to be created for additional liquidity, which can happen only if the market achieves a certain minimum depth.

Although in terms of numbers, the market may look impressive, most of the shares listed on the local markets are illiquid, with very little scope for genuine trading. In a majority of high-profile stocks with earning potential, the free float portion is very limited.

This actually distorts the market and leads to over-exaggeration.

It is high time that the banks showed more concern about what happens to the money they are advancing to clients and where exactly the funds end up. Laxity can have consequences for both creditors and the debtors.

Past experiences of neglect in this respect have been bitter and it is only prudent that effective systems be put in place to monitor use and misuse of bank credit. This is a serious challenge for both banking supervisors as well as market regulators.