Famously one of the most diverse in the region, the Bahraini banking sector is composed of local, regional and international firms which have flourished in a liberal but well-regarded regulatory environment. The past year has been a challenging one for the industry, particularly given the unrest in the early months, yet most licensed lenders in Bahrain entered 2012 on the back of robust financial results and – thanks to a government policy of fiscal expansion – with the prospect of new business opportunities in the short term. While challenges remain, including the effects of the global economic crisis, there is a palpable sense of optimism around this most important of Bahrain’s industries.

The emergence of other commercial centres in the Gulf has brought more competition, but Bahrain retains a number of advantages. A large, highly skilled pool of financial workers, a regulatory structure that is both advanced and internationally well regarded, and a physical connection to Saudi Arabia, by far the largest economy in the Gulf, make Bahrain an attractive destination for the global banking industry.

MARKET STRUCTURE & PLAYERS: Bahrain differs from most of its regional neighbours in that its realisation that its oil supply was limited encouraged it to adopt a strategy of economic diversification at an early stage. While oil and gas exports still play a major part in the economy, Bahrain’s financial sector – accounting for around 25% of GDP – is the largest non-oil contributor to the national balance sheet and is of central importance to the country’s economic development.

Within the financial sector, banks operating in Bahrain account for over 85% of financial assets, according to the Central Bank of Bahrain (CBB), and together make up a dynamic market of local and foreign players divided by the licensing regime into conventional and Islamic, retail and wholesale. As of March 2012, the CBB register held 23 conventional retail banks, eight of which were locally incorporated and 15 of which were headquartered abroad. Bahrain’s local retail banking segment is dominated by three players which run branch networks that are considerably larger than their colleagues: NBB (25 branches), Ahli United Bank (20 branches) and BBK (formerly the Bank of Bahrain and Kuwait, 16 branches). Other retail banks operating in the Kingdom maintain networks of between two and six branches or, in some cases, conduct their business from a single head office. The single-branch model is most often adopted by foreign retail banks, such as BNP Paribas, Credit Libanais, ICICI Bank and National Bank of Abu Dhabi, although some foreign players, such as HSBC and Citibank, maintain slightly larger networks.

Wholesale banks, known as offshore banks until a 2006 reorganisation of the sector, may not operate branch networks but can do business with non-resident individuals and firms which do not maintain an office in Bahrain, and can also compete for business with local individuals and firms subject to restrictions set by the CBB. As of March 2012, 55 conventional wholesale banks were licensed to operate: locally incorporated players such as Arab Banking Corporation (ABC), Gulf International Bank, Investcorp, TAIB Bank and the International Banking Corporation; regional banks such as Jordan’s Arab Bank and Saudi Arabia’s Arab Investment Company; and global operators, such as Pakistan’s Allied Bank, India’s Bank of Baroda, the Philippines’ Allied Banking Corporation, Finansbank, DenizBank and Türk Ekonomi Bankası of Turkey, and the US’s JP Morgan. Some foreign banks in Bahrain, such as Citibank, Standard Chartered, National Bank of Abu Dhabi and BNP Paribas, hold both a retail and wholesale licence. Bahrain’s reputation as a centre of Islamic finance stems largely from the presence of seven sharia-compliant retail banks and 20 wholesale operators, all but one of which are locally incorporated.

PERFORMANCE: The performance of Bahrain’s banks in recent years follows a pattern seen elsewhere in the Gulf region. The sector showed a rapid expansion of assets in the years prior to the global economic crisis, peaking in 2008 at $252bn, followed by a contraction as the effects of the crisis took hold and banks addressed the problem of impaired assets on their balance sheets. By December 2011 total sector assets had settled at $197.1bn, according to the CBB’s January 2012 “Statistical Bulletin”. Despite the unique challenges posed by 2011, aggregate sector performance across primary indicators remained positive for the year. According to CBB figures, year-on-year asset growth reached 2.6% in 2011, lending growth hit 14.9% and deposit growth registered a 10.1% rise.

Bahrain’s wholesale banks, which had grown their assets on the back of the pre-crisis Gulf real estate boom, were particularly hard hit by the global economic slowdown. Two of them – Awal Bank and the International Banking Corporation – defaulted on debts and were placed under the administration of the CBB, while a third – Gulf International Bank – initiated a capital restructuring plan with the objective of recapitalising the bank. Beyond the drop in construction finance, wholesalers face a reduction in trade finance and structured currency transactions, and have therefore spent 2010 and 2011 working to diversify their balance sheets, with some of the larger players moving into the more promising retail and Islamic segments.

Retail banks, which were less affected by the changing economic backdrop, have also engaged in an extended period of balance sheet cleaning and provisioning, but have in general experienced a more even recovery in the years since the financial crisis. Consumer lending continued to grow in 2011, with NBB, BBK and Ahli United Bank (AUB) – the three locally incorporated retail players which dominate the consumer market through their branch networks – registering rises in loans and advances of 2.23-10.22% over the year.

POLITICAL UNREST: A potential threat to the sector’s recovery emerged in early 2011 in the form of political unrest which significantly affected business in the Kingdom for some time and threatened to tarnish its reputation as an efficient centre of financial services. However, the 2011 performance of the banks suggests that, as in other markets, regional and global issues have a greater bearing on the performance of Bahrain’s banks than local ones (see analysis). Significantly, CBB figures show withdrawal rates for retail deposits stayed within the normal range during the first quarter of the year, when the unrest was at its height, and the 2011 financial statements of Bahrain’s banks revealed the sector’s recovery from the 2008/09 economic slowdown continued. Moreover, during the peak of the local unrest, the payment system did not witness a single failure.

VARIED IMPACT: Three of nation’s five largest banks by total assets benefit from diverse geographical footprints that enable them to transcend local challenges: the AUB Group, ABC and the Al Baraka Banking Group posted gains in net profit of between 10% and 45% for 2011. Banks more focused on the Bahrain market, with the largest branch networks, showed mixed results. BBK posted a 18.8% drop in net profit as result of unexpected provisioning levels, NBB showed a 6.1% gain for the year, while BMI Bank announced a net loss of $8.97m (an improvement on the $70.3m loss of 2010).

Of Bahrain’s five largest banks by total assets, four posted decreases in provisions against impaired loans and advances, while BBK’s provisioning against non-trading investment securities rose by 50.8% and NBB’s overall provisioning rose by 133% for the year – a fact that did not prevent it from posting a net profit. For many of Bahrain’s banks, 2011 marked the end of the period of heightened provisioning which began in 2008. “The era of provisioning is over for the most part. Most people I interact with have absorbed the damage and cleared up their balance sheets,” Mohammed Ahmed Abdulmalik, the CEO of Capivest, told OBG.

LENDING OPPORTUNITIES: The fact that the liquidity of Bahrain’s banks did not suffer as a result of 2011’s unrest is of central importance to the sector’s ability to grow in the short and medium term. The challenge for 2012 is finding lending opportunities that suit banks’ revised risk profiles. Many in the industry believe that quality, long-tenor financing opportunities will come with the government’s plans to boost spending on national infrastructure projects. The expansionary fiscal policy propounded by the government is in part a response to the political demands voiced during 2011, and as such contains a heightened degree of social spending. Here, too, lie potential opportunities for lenders, particularly in the affordable housing segment, where 15-year waiting lists for units have emerged as a particular source of grievance. “There is a lot of pressure to build low-income housing now. Government housing represents a possible lending opportunity – we haven’t seen it yet but it’s of interest to us,” Hassan Jarrar, CEO of Standard Chartered Bahrain, told OBG.

The ability of Bahrain to deliver on its spending promises is underwritten by support from its neighbours in the Gulf. In April 2012 the government announced that it would soon give details of a $10bn GCC-funded stimulus package providing for capital expenditure on new projects and targeted repayments intended to improve Bahrain’s sovereign debt rating – both of which potential developments are important to the banking sector.

Lending for small and medium-sized enterprises (SMEs), although experiencing downward pressure as a result of business interruptions over the past year, is seen as promising in the longer term as a result of the emphasis placed by the Vision 2030 development strategy on nurturing enterprise activity in the economy. Government body Tamkeen is charged with positioning the private sector as the key driver of economic development, and by 2011 had disbursed more than BD100m ($264m) in portfolio loans to financial institutions – around BD70m ($184.8m) of which went to its principal banking partner, the Bahrain Development Bank.

CREDIT BUREAU: All major banks have established SME divisions to target this small but growing segment, the activities of which will be made considerably easier if plans to establish the Corporate Credit Reference Bureau, originally scheduled for 2011, are implemented. For now, credit information coverage is provided by the Credit Reference Bureau and is limited to the consumer segment. This has been managed since 2005 by the Benefit Company, often described as the nervous system of the banking industry. “The Corporate Credit Reference Bureau will have a positive impact on the economy because it will reduce the amount of defaulted loans and help to limit the number of companies that over-extend themselves and go bust,” Abdulwahid Janahi, the CEO of the Benefit Company, said.

The company was granted a special licence to provide ancillary services to the financial sector in the late 1990s and has controlled the point-of-sale switch and national ATM since 1997. As of 2011 it oversees around 350,000 active accounts in its capacity as credit information provider, and its decade-long presence has set Bahrain apart from other jurisdictions in the Gulf. “Benefit is a leading credit bureau in the region. We rely heavily on it in extending credit. … We exchange data with them and make decisions based on the data we receive in return,” Mazin Khoury, the CEO of American Express Middle East and North Africa, told OBG.

MARKET TRENDS: The strategies currently being implemented by most retail banks were established in the wake of the global economic crisis, and as such are focused on cost-cutting on the one hand and diversification of revenue and – in many cases – expansion into regional markets on the other. In this regard, retail banks operating sizeable domestic branch networks have continued to add outlets during 2011 and worked at establishing multi-channel networks to expand their business. In 2011 BBK opened a branch in the Seef district, established eight new offsite ATMs and introduced BBKC ashlink, an internet-accessible payment management system. NBB, meanwhile opened a branch in Budaiya, refurbished four others, strengthened its direct sales distribution channel, launched a new nillimit debit card aimed at the mass market and is developing a corporate internet banking service.

B Chandrasekhar, the CEO of Arab Financial Services, told OBG that another big trend in the market involves outsourcing. “More and more banks are outsourcing their card services and value-added services. This allows the banks to focus on their core activities, while offering a better end service to their customers.”

Some wholesale banks, which have traditionally used cost-effective foreign funding to lend and invest in regional markets, have announced changes to their business plans in response to an incipient retrenchment of European funding. ABC, for example, which operates in Bahrain on a wholesale licence, but runs retail operations in North Africa and Jordan, has said it will alter its Bahrain business model to become a deposit-taking bank to reduce its reliance on wholesale funding. While the sector awaits the lending opportunities which are expected to emerge in the second quarter of 2012, some foreign banks have retrenched from lending and concentrated instead on corporate and financial advisory, wealth and asset management, and trade finance and cash management due to global regulatory reform.

All of Bahrain’s banks, both retail and wholesale, have been concerned with capital preservation and prudent liquidity build up, and this will remain a feature of the market as it adjusts to the altered economic climate and regulatory changes introduced by the CBB.

COST CONTROL: The cost-cutting measures undertaken by Bahrain’s banks mirror those seen elsewhere in the region. Banks have sought to streamline internal processes and reduce payroll expenses, although the layoffs which resulted in 636 banking sector job losses in 2009 slowed considerably in 2010 and 2011. The importance of cost cutting and efficiency has renewed interest in consolidation – long seen as necessary but made difficult as a result of regional banking culture and ownership structures. The central bank has urged several Islamic banks to merge to strengthen their capital bases (see Islamic Financial Services chapter), but many in the industry see the consolidation route as an option for some conventional banks – particularly smaller operators with less robust balance sheets seeking greater stability and efficiency.

However, the unsuccessful conclusion of negotiations between Bahrain Islamic Bank and Al Salam Bank in February 2012 underlined the difficulties of merger activity that is a characteristic feature of many markets in the region. “Our challenge here is that the institutional shareholders are the big families, who wish to retain control. This is the biggest challenge to successful mergers in this market, similar to the UAE,” said Jarrar.

LEGISLATION: The CBB’s approach in establishing and maintaining its regulatory framework has been weighted towards enabling economic activity while maintaining international best practice and transparency, and its efforts have been central to Bahrain’s 2012 number-one ranking in the Index of Economic Freedom, published annually by the Wall Street Journal and the Heritage Foundation – in which it the only country in the MENA region to feature in the top 20. The primary legislation by which the sector is regulated is the CBB and Financial Institutions Law 2006, the Anti Money Laundering Law of 2001 and the recently revised Corporate Governance Code. The CBB also possesses a flexible regulatory tool in the form of the CBB Rulebook, the first two volumes of which are devoted to conventional banks and Islamic banks, respectively.

RESERVE REQUIREMENTS: The CBB’s activity in managing liquidity in the economy has also been of signal importance to the banking sector. The prudential approach adopted by the CBB granted it considerable leeway in its response to the tightening credit environment in the wake of the global economic crisis, and its swift response to the events of 2007 and 2008 was instrumental in the sector’s ability to withstand this difficult period with relatively undiminished balance sheets.

Retail banks are required to deposit reserves with the CBB, and its ability to set this reserve requirement represents one of its most powerful liquidity management tools. In early 2009 it cut the reserve requirement for banks from 7% to 5% in a bid to support credit growth, a move which helped to mitigate the more cautious lending stance as banks embarked upon the process of writing down investments and provisioning for impaired loans. The reserve requirement of each commercial bank continues to be calculated on a monthly basis using data provided by the banks. It remains the primary means by which the CBB can adjust its structural liquidity situation vis-à-vis the banking sector. The CBB can influence the deposit and lending rates that the banks offer to customers through its offering of a set of deposit and lending standing facilities, the interest rates on which are the CBB policy interest rates. These guide the short-term interest rates in the domestic money market. As the Bahraini dinar is pegged to the dollar, the CBB’s policy rates remain closely aligned to US interest rates as set by the Federal Reserve.

In December 2008, for example, it cut its key policy rate by 75 basis points after reviewing a decision taken by the Federal Open Market Committee. This brought the rate of its one-week deposit facility to 0.75% from 1.5% previously. The rate was subsequently lowered by a further 25 basis points to stand at 0.5%, where it remains as of April 2012. The CBB, however, does not maintain any administrative controls over market interest rates. Following a free market policy, there are no interest rate caps or floors, and the private sector is free to allocate credit as it sees fit.

CONSUMER FOCUS: During 2011, the CBB shifted its focus towards consumer protection, a process which has seen the establishment of a deposits and unrestricted investment accounts protection scheme and the introduction in 2007 of a consumer finance and charging code. In 2011 the latter was developed into directives, which address issues of fair treatment and transparency and introduces a complaint mechanism. “Now we are assessing the level of fees and charges that the retail banks and financing companies levy, after receiving a number of complaints. We are in the final stages of surveying a wide range of bank charges, which we will then assess before deciding how to react,” Khalid Hamad, the executive director of the CBB’s banking supervision unit, told OBG.

BASEL III: Looking ahead, the primary regulatory challenge for the sector is the implementation of Basel III. Although not obliged to implement its provisions, Bahrain has built its reputation as an international centre for finance partly through its adoption of international best practice, including the previous iterations of Basel, and the CBB intends to maintain this record.

Having conducted impact assessments on Bahrain’s banks in 2010 and 2011, in 2012 the CBB is establishing committees that will help local lenders to work through the critical issues arising from the implementation of the new standards – which will be a phased process commencing in 2013. While the capital requirements of Basel III are not problematic for most of Bahrain’s banks, which have a preponderance of Tier-1 capital on their books, Basel’s liquidity provisions may require some banks to realign their business models.

Another matter of interest for international banks operating in Bahrain is the Basel III implementation timetable expected to be announced by the CBB before the end of 2012. A variance between local deadlines and those in the home markets of international players may have implications for these banks.

OUTLOOK: Bahrain’s banking sector displayed its resilience during 2012 and, far from there being a flight of capital or institutions from the country, the CBB announced that it had issued eight licences to new entities. There are certainly challenges ahead, most notably for Bahrain’s wholesale banks whose traditional reliance on funding from European banks has resulted in a potential vulnerability. According to ratings agency Moody’s, approximately 40% of the $120bn liabilities held by wholesale operators is European in origin.

The wider sector has shown that it has made significant progress in adjusting to the economic challenges posed by a cooling global economy and, while the recovery of the sector is as incremental, its continued growth is largely underwritten by a government determined to safeguard the Kingdom’s economic development.