The Kingdom of Bahrain is synonymous with Islamic finance, and plays host to the largest concentration of sharia-compliant institutions in the Middle East. Islamic banks, insurance (or takaful) companies and investment firms have thrived within a regulatory regime which was one of the first in the world to recognise the importance of establishing best-practice standards for the industry.

The Islamic banking and insurance modules of the Central Bank of Bahrain (CBB) have done much to establish the country as a global centre of Islamic finance, while the presence of numerous industry bodies – most notably the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) – places Bahrain at the forefront of industry development (see analysis). A history of clear regulation and prudent oversight has served the sector well in the challenging years since the onset of the global economic downturn. It also accounts for the sense of optimism within the sector, despite the challenges that are facing the broader global finance industry.

HISTORY: Bahrain’s emergence as a regional financial centre in the 1970s coincided with a renewed interest in the concept of Islamic finance – one engendered by a handful of young Muslim economists that believed an Islamic alternative existed to standard banking, which, though integral to modern economic development, did not comply with the principles of sharia. In 1979, Bahrain Islamic Bank (BIsB) was established as the first Islamic lender in the Kingdom, and over the following decade it was joined by more sharia-compliant institutions as Bahrain’s reputation as the GCC’s financial centre grew.

By 1990, the regional Islamic financial institutions, which had gathered that year in Algiers to establish the AAOIFI, viewed Bahrain as a natural home for the new organisation. In 2001, Bahrain became the first country in the world to implement regulations specific to the Islamic banking industry, since which time the CBB Rulebook has been widely regarded as the benchmark for sharia-compliant governance. In the same year, the nation sealed its reputation for innovation in Islamic finance when the central bank (then the Bahrain Monetary Agency) became the first in history to develop and issue sukuk, or Islamic bonds.

By 2005, a comprehensive regulatory framework had been implemented for Manama’s growing takaful and retakaful industry, while the following year the CBB, in partnership with Islamic financial institutions, established the Waqf Fund as part of its strategy to maintain the nation’s position on the front line of global Islamic finance. Since then the fund has financed a range of research, education and training projects and worked with industry participants to develop new market standards. In 2011 the opening of the Bahrain Financial Exchange (BFX) added new depth to the country’s capital markets and brought with it an Islamic platform, the Bait Al Bursa, which has broken new ground with its sharia-compliant instruments and represents the latest in a long series of sharia-compliant innovations to emerge from Manama.

BANKS: As of April 2012, some 27 Islamic banks are licenced by the CBB to operate in Bahrain, all but one of which (Kuwait Turkish Participation Bank) are locally incorporated. The sector is effectively divided into two subsections. Seven retail institutions serve the local market, offering sharia-compliant products to both nationals and expatriates, while 20 wholesale Islamic banks are granted only limited access to the local economy and instead primarily operate as offshore investment entities.

Bahrain’s retail and wholesale Islamic lenders offer an array of sharia-compliant products and services, such as murabaha, mudaraba, ijara, musharaka, Al salam and istitsna’a, restricted and unrestricted investment accounts, syndications and other structures found in conventional finance which have been modified to comply with sharia principles. Within the wider Islamic finance sector, the expansion of Islamic banking has been quite rapid, with aggregated sector assets rising from $1.9bn in 2000 to an historic high of $25.5bn in 2009, according to data from the CBB – an increase of over 12 times.

MARKET SHARE: Over the same period the market share of Islamic banks increased from 1.8% of total banking sector assets to 11.1%, making it one of the most dynamic Islamic banking sectors in the world. On the retail side, Islamic arms of banking groups with a regional footprint, such as Al Baraka, compete for business with locally incorporated banks. Of the latter, Ithmaar Bank operates the largest branch network (15), followed by Bahrain Islamic Bank (13), Bahrain Saudi Bank (9) and Kuwait Finance House (9).

The more fragmented wholesale segment contains industry veterans such as Capivest, which received its licence in 1981; the Islamic operations of regional conventional giants, such as ABC Islamic Bank; the wholesale divisions of large retailers, such as Al Baraka; and investment firms with a presence in other financial capitals, such as Arcapita. Much of the pre-crisis expansion was driven by a regional property boom during the mid-2000s. Wholesalers, in particular, were attracted to the real estate sector as it suited a physical asset-based finance model demanded by sharia. Outside real estate development banks such as International Investment Bank invested in areas like the food industry and affordable housing.

AFTER THE CRISIS: However, this concentration of assets became problematic after 2008, as declining real estate prices resulted in loan impairments and the heightened provisioning levels which were largely responsible for the aggregate negative earnings seen in this period. From the high of $25.5bn in 2009, total assets for the Islamic banking sector contracted to some $24.3bn after the crisis.

However, while wholesale banks look to restructure their asset base and await a return to profitability, the retail segment shows a move towards growth. Al Baraka Islamic posted a net income rise of 249% in the first nine months of 2011, while Ithmaar Bank, BIsB and Bahrain Saudi Bank – which have the largest branch networks in the country – all showed a return to profit in 2011 after the losses of 2010. As the recovery continues, the CBB has urged the wholesale segment to consider consolidation as a means to creating more robust balance sheets. In 2011 it announced that two mergers were under consideration and would shortly be put before shareholders for approval: Al Salam Bank would join forces with BIsB, while Capivest, Elaf Bank and Capital Management House would combine in a three-party consolidation.

“Consolidation among small and medium-sized Islamic banks in Bahrain should be encouraged,” Aabed Al Zeera, the CEO of International Investment Bank, told OBG. “Some of these banks currently do not have the capital requirements to adhere to the strict guidelines outlined in Basel II and Basel III.”

While discussions between Al Salam and BIsB ended in the first quarter of 2012 without agreement, the momentum behind the long-awaited consolidation trend has not lessened (see analysis). Finally, Bahrain is also host to a number of Islamic windows of conventional banks, including those of Standard Chartered, Ahli United Bank, BMI Bank, GIB, BNP Paribas, Investcorp and HSBC. While some Gulf jurisdictions have moved to close down the Islamic window system, in 2011 the CBB stated it had no intention to apply such a regulatory change in Bahrain.

TAKAFUL: The growth of sharia-compliant lending has in recent years fuelled the rapid expansion of Bahrain’s takaful sector. As of March 2012, seven insurance companies in Bahrain carried out their operations according to the principles of sharia: Chartis Takaful Enaya, Legal and General Gulf Takaful, Medgulf Allianz Takaful, Solidarity Family Takaful, Solidarity General Takaful, Takaful International Company and T’azur Company. As with many other areas of Islamic banking, takaful has grown more rapidly than its conventional counterpart over the past decade, as products have grown in sophistication and the concept of sharia-compliant insurance has overcome traditional resistance in the region. According to CBB data, in 2001 takaful firms contributed BD1.89m ($4.99m) to Bahrain’s gross premiums, representing about 3% of the total; by 2010 this figure had risen to BD38.55m ($101.78m), or 18% of the sector total. General takaful business, in particular, has shown significant growth during this period, accounting for 85% of total takaful contributions in 2010, and 15% of the entire insurance sector. Since the 2006 arrival of Hannover Re, Bahrain has also been home to a retakaful market. A second provider, ACR Retakaful, joined in 2008, and the gross contributions of retakaful firms grew from BD5.72m ($15.1m) in 2007 to BD78.12 ($206.25m) in 2010. In that year, reinsurance carried out according to sharia-compliant principles accounted for 24% of the total. The lack of takaful capacity that was a challenge to sharia-compliant insurers some years ago is, therefore, no longer a concern. “Some 70% of our panel of reinsurers are retakaful players, so there is no problem. Capacity has been building up, and has been adequate for about five years now,” Ashraf Bseisu, the group chief executive at Solidarity, told OBG.

ISLAMIC INVESTMENT: As the first country in the world to allow its central bank to develop and issue a sukuk, Bahrain is regarded as a pioneer in the field of sharia-compliant investment. It has established itself as a frequent sukuk issuer in the debt capital markets and, while sukuk issuance in Bahrain slowed in the wake of the global economic crisis in line with international trends, the CBB maintains a successful record of sharia-compliant debt issuance continuing to this day.

After cancelling a conventional bond sale in the early part of 2011 as a result of political unrest, the CBB’s decision to hold a sukuk sale later that year was observed with more interest than usual. On November 20, 2011, Bahrain successfully placed a $750m, seven-year sukuk in a sale which, according to a statement from the CBB, “develops the Kingdom’s presence in the international sukuk market and affirms its commitment to Islamic financing”.

The transaction, which was oversubscribed, marked the fourth time that the country has gone to the international markets with a sukuk, and is its first sukuk offering at a seven-year tenor. As of March 2012, of the 11 debt instruments that are listed on the Bahrain Bourse, eight are sharia-compliant, the largest of which is the $1m Dar Al Arkan 2 sukuk, a 2007 offering that is due in 2012.

AN EXCHANGE OF ITS OWN: The sharia-compliant market was granted new depth in 2011 with the opening of the BFX and its Islamic division, Bait Al Bursa. It is the first dedicated platform in the region to offer exchange-traded solutions to the Islamic finance market, and will house what the BFX hopes will be a steady stream of innovative sharia-compliant financial products. The first of these to be launched is e-Tayseer, a fully automated platform for the supply, purchase and sale of assets to facilitate murabaha transactions.

With the new platform, registered users are able to buy assets placed on the exchange to use as the underlying asset required by sharia for their murabaha transactions, while counterparties can meet their liquidity requirements. In this sense, it is a sophisticated liquidity management solution provided through an automated exchange system, and the first of its kind in the region. “There is a plain vanilla approach to Islamic finance, adopted by other exchanges, which is just listing Islamic exchange traded funds or equities,” Arshad Khan, the managing director and CEO of the BFX, told OBG. “This is simple to do and is one of our approaches. But if you want to broaden the market you need to bring in more sophisticated products, more volume-based business, you need something like murhabara – which e-Tayseer does.”

REGULATION: The BFX was an initiative supported by India’s Financial Technologies Group, which chose Bahrain for its latest exchange for a number of reasons, one of the most salient of which is its internationally well-regarded regulatory system. The CBB, as regulator of the entire financial services sector, provides one of the most comprehensive regulatory frameworks in the region in the form of its CBB Rulebook, the six volumes of which cover conventional banks, Islamic banks, insurance licences, investments firm licences, specialised licences and capital markets.

The CBB worked closely with the BFX prior to its launch to ensure that its products met its requirements. “We have been working with them behind the scenes, approving their rulebook, ensuring their employees met all the right criteria,” Liam Richard Gibbon, a capital markets adviser at the CBB’s Capital Markets Supervision Directorate, told OBG. “They use all the Financial Technology Group products, which we are comfortable with as they are also used in many other exchanges. We have reviewed 20 or so products over the past year, and some of those are being introduced in the first quarter [of the year 2012]. We have approved five formally so far, four of which are currently already being traded.”

Beyond the CBB Rulebook, sharia-compliant financial activity is subject to a number of national laws, including the CBB, the Financial Institutions Law of 2006 and the Bahrain Anti Money Laundering Law of 2001. Oversight of the sector is undertaken by the Islamic Financial Institutions Supervision Directorate (IFISD), which maintains a similar regime as the one which is applied to the conventional sector. “We meet [Islamic] banks formally at least twice a year,” Hussain Ali Sharaf, the director of the IFISD, told OBG. “We have a prudential meeting with a CEO and his team, and an end-of-year financial review when we go over the bank’s financial report before it goes to their board. If we are concerned about an institution’s performance, we may then call them in two or three more times over the course of the year.” Bahrain is host to several organisations playing a key role in the propagation and standardisation of the global Islamic finance market, such as AAOIFI, the Liquidity Management Centre, the International Islamic Financial Market, the General Council for Islamic Banks and Financial Institutions and the Islamic International Rating Agency.

OUTLOOK: The presence of such a large number of industry bodies which exert an influence far beyond the borders of Bahrain is one of the reasons why the country will remain a key player in the global Islamic financial service industry. The CBB, meanwhile, maintains a proactive stance in relation to the domestic industry, as its encouragement of the process of market consolidation demonstrates. Like their conventional counterparts, the future profitability of Bahrain’s Islamic financial institutions lies in the nation’s proximity to large regional markets and the presence of a sizeable pool of skilled financial workers that are the result of decades of financial sector growth.

In the short to medium term, the elevated development spending of a government keen to address the social issues which came to prominence in 2011 will both mitigate the effects of regional unrest and help deal with the secondary issues currently arising from the slow recovery of the cooling global economy. Challenges lie ahead, particularly for Islamic wholesale banks addressing impaired assets and adopting new business models. However, there are also many opportunities for sharia-compliant lending, insuring and investing that remain within the reach of Bahraini firms practicing various forms of Islamic banking.