Bahrain emerges as a leading regional player in the Islamic financial services sector

Reduced oil prices and fiscal austerity measures being carried out by governments across the GCC have resulted in a challenging environment for Bahrain’s sharia-compliant financial institutions. The competitive domestic market – home to the largest concentration of Islamic financial institutions in the Middle East – has reacted to adverse conditions with what appears to be the beginning of a long-awaited period of consolidation: both the banking and takaful (Islamic insurance) segments saw significant merger and acquisition activity over the past year. The sector also received notice in 2017 of a change in the regulatory framework that will usher in a new era of oversight.

REGIONAL CENTRE: For much of the 20th century financial activity in Bahrain was carried out along conventional lines. The leader until 1932, Sheikh Isa bin Khalifa, was an opponent of the modern concept of Islamic finance, and this set the tone for decades after his departure. The growth of the financial sector, therefore, was in its earliest days led by conventional foreign players, such as the UK-owned and India-headquartered Oriental Bank, which arrived in the market nearly 100 years ago.

From the late 1950s the local institutions that began to emerge, such as National Bank of Bahrain, emulated the conventional operations of their foreign counterparts, establishing Manama as a financial centre. The kingdom’s first sharia-compliant bank, Bahrain Islamic Bank, was not established until 1979, but over the following decade it was followed by several Islamic institutions, some of which retain a prominent position in the market today.

Bahrain was soon established as a centre for sharia-compliant, as well as conventional, financial activity – a status that was cemented in 1990 when regional Islamic financial institutions chose the kingdom as the home of a new standard-setting body, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The presence of the AAOIFI helped establish Bahrain at the leading edge of Islamic financial services (IFS) regulation. The AAOIFI’s sharia board, made up of scholars from across the GCC, Malaysia, Iran, Sudan, Pakistan and the US, has emerged as the global IFS industry’s most influential fiqh (Islamic jurisprudence) body, establishing standards which have been fully adopted in Bahrain, and used as an important reference for regulators across the world.

Bahrain is also home to the Islamic International Rating Agency (IIRA), which has positioned itself as an alternative to the three major credit ratings agencies – Fitch, Standard & Poor’s and Moody’s – with a focus on sharia-compliant institutions.

As of 2017 the agency was producing ratings for eight GCC financial institutions, as well as issuing a sovereign rating for Bahrain. In recent years it has expanded from its GCC activities to cover institutions in Jordan, Egypt, Turkey, Syria, Lebanon, Sudan and Pakistan. Its array of products, meanwhile, has expanded to include ratings for sovereigns, Islamic banks, sukuk (Islamic bonds), takaful and sharia quality, as well as services such as financial assessments, training workshops, seminars and country reviews.

Other Manama-based institutions add to Bahrain’s status as an influential participant in global IFS, including: the International Islamic Financial Market (IIFM), which establishes standards for Islamic capital and money markets; the General Council for Islamic Banks and Financial Institutions; and the Sharia Review Bureau. More recent arrivals include the Thomson Reuters Global Islamic Finance Hub, Deloitte’s Islamic Finance Knowledge Centre, and the Islamic Centre at Bahrain Institute of Banking and Finance, which offers undergraduate and postgraduate courses on sharia-compliant finance.

BANKING: Since the establishment of Bahrain Islamic Bank, a rising appetite for sharia-compliant financing has seen the domestic Islamic banking sector expand to claim a market share of around 30%, according to global financial services firm EY.

As of November 2017 six Islamic banks were licensed to carry out retail banking activity in the kingdom, all of which were locally incorporated: Bahrain Islamic Bank, Al Baraka Islamic Bank, Al Salaam Bank, Ithmaar Bank, Khaleeji Commercial Bank and Kuwait Finance House (KFH). Most of these operate modestly sized networks of between seven and 10 branches, though by the end of 2017 Ithmaar had established 16, while Khaleeji Commercial maintained the second-largest network with 11. The institutions offer a wide range of products and services to the domestic market, as well as restricted and unrestricted investment accounts, syndications, and other structures found in conventional finance.

Another 18 banks operate under wholesale licences, granted access to the local market but primarily functioning as offshore investment entities, each maintaining only a single branch in Bahrain. They form a diverse strata of the industry, made up of the sharia-compliant windows of global players such as Citi Islamic Investment Bank, the wholesale divisions of Islamic retailers, and large investment firms with a presence in other financial capitals.

PERFORMANCE: The domestic Islamic banking industry has expanded rapidly since the turn of the century. According to the Central Bank of Bahrain (CBB), total assets in the segment rose from $1.9bn in 2000 to reach $25.4bn in 2012 – a 12-fold increase. However, a crowded domestic market and low oil prices have combined to create a challenging business environment over the past three years. The Islamic retail segment showed a modest return on assets (ROA) of 0.2% between September 2015 and September 2016, according to the CBB’s “Financial Stability Report”, compared to 0.4% the previous year. The wholesale segment also showed ROA of 0.2% in that period, although this represented an improvement on the -0.1% of the previous year.

The sector’s financial soundness indicators are robust, with aggregate capital adequacy ratios of 17.1% for retail institutions and 19.1% for wholesale operations, which are well in excess of the regulatory minimum. However, the sector does exhibit vulnerability in the area of non-performing facilities, which stand at 12% of gross financing for the retail segment. Financing extended to the construction sector showed the highest level of impairment, at 29.4% in September 2016, up 7.6% on the previous year. The wholesale segment has been less adversely affected by non-performing facilities, which stand at 2.9% of their gross financing.

POTENTIAL CHANGES: Performance pressures have resulted in increased speculation regarding consolidation of the regional banking industry, with the GCC’s Islamic banks coming under particular scrutiny. A recent research note by UC apital asserted that the combined assets of the top-four conventional lenders in the GCC were larger than those of the entire Islamic banking sector in the region, a phenomenon which highlights the value of Islamic institutions combining their balance sheets if they are to compete with the larger players.

The last significant merger activities in the GCC Islamic banking sector came in 2012 and 2013, when Bahrain’s Elaf Bank and Capital Management House merged to form Ibdar Bank, and Dubai Bank merged with Emirates Islamic Bank and Capivest.

In 2017 Manama was again the focus of merger and acquisition speculation when news emerged that Ahli United Bank was in talks with KFH over a merger that would create the sixth-largest bank in the GCC, with assets of nearly $90bn. Ahli United is Bahrain’s largest lender and has operations in Kuwait, Egypt, Iraq, Oman, Libya and the UK, either directly or through affiliates. Its sharia-compliant business is carried out under its Al Hilal brand name. The operations of fully sharia-compliant KFH, meanwhile, are primarily focused in Kuwait and Turkey, and include relatively small operations in Malaysia and Bahrain. The differing geographic footprints of the two institutions might make for a challenging integration process, but both would benefit from increased asset diversity and economies of scale.

TAKAFUL: The growth of Islamic banking in Bahrain has supported the expansion of the wider IFS sector, which includes a sizeable sharia-compliant insurance industry. The kingdom’s first takaful company, Takaful International, opened in Manama in 1989, and since then the market has expanded to include a further five firms as of November 2017: Al Hilal Takaful, Chartis Takaful Enaya, Medgulf Takaful, Solidarity General Takaful and T’azur Company.

These firms operate within a wider insurance sector made up of 24 locally incorporated institutions and 12 overseas firms, which include some of the biggest brands in the global industry, such as Hannover Re and New Hampshire Insurance Company.

In this competitive arena, Bahrain’s takaful providers have grown at a rapid pace, with the sharia-compliant market expanding almost 14 times in terms of premiums between 2003 and 2014. Gross contributions (the sharia-compliant equivalent of premiums) accounted for 22% of the insurance sector’s total premiums in 2016, according to the latest CBB data. After a difficult 2015 the takaful segment returned to profitability in 2016, posting an aggregate net profit of BD520,000 ($1.38m) against a loss of BD694,000 ($1.84m) the previous year.

The emerging takaful segment is also helping to drive the expansion of a sharia-compliant reinsurance, or retakaful, industry in Bahrain. The CBB issued its first retakaful licence in 2006 to Hannover Retakaful, which has since been joined in the market by ACR Retakaful. These companies together claimed BD60.7m ($161m) in gross premiums in 2016, which represented 16% of the total reinsurance market in Bahrain. Both of the kingdom’s sharia-compliant reinsurers were profitable in 2016, posting an aggregate of BD4.8m ($12.7m), against a loss of BD21.9m ($58.1m) in the previous year.

JOINING FORCES: Bahrain’s takaful companies operate in a highly competitive environment where the contest for market share is largely fought on pricing rather than service. In some parts of the insurance industry firms have written policies at terms below the cost of capital to gain a competitive advantage.

The regulator has been vocal in its calls for consolidation as a way of easing competition and establishing a sustainable industry. While both conventional and takaful providers have historically shown reluctance to combine their balance sheets, the challenging recent economic environment has given fresh impetus to a regional consolidation trend.

In Bahrain, the takaful segment was the origin of one of the most significant mergers of 2017. In August the shareholders of Solidarity General Takaful and Al Ahlia Insurance Company gave their approval for a merger that is expected to result in a rebranded entity known as Solidarity Bahrain. The new company will have paid-up capital of BD11.2m ($29.7m) and an estimated market share of 15%, making it the largest takaful firm in the kingdom.

Earlier in 2017 Bahrain Kuwait Insurance (BKI) signed a memorandum of understanding with Bahrain Islamic Bank to buy its full stake in Bahrain’s Takaful International. The deal brings BKI’s holding of Bahrain Takaful to nearly 64%. Given the slow recovery forecast for global oil prices, this nascent trend of consolidation is expected to continue over the medium term, with domestic insurers seeking to boost their solvency and ability to gain market share by aligning themselves with suitable competitors.

ISLAMIC INVESTMENT: The growth of the IFS sector in Bahrain has been assisted by the government’s positive disposition towards it. Establishing the kingdom as a regional centre for sharia-compliant financial activity has been a priority for some years, and one result of this is the advanced regulatory framework implemented by the CBB.

Bahrain is also one of a small number of nations to include a sukuk issuance programme in its public debt management strategy. The Bahrain Monetary Agency, the precursor to the CBB, issued the first sovereign sukuk based on an ijara (leasing contract) structure in 2001. Over the following years the kingdom became the region’s most active sukuk issuer, offering 94 international instruments worth a total of $6.8bn between 2001 and 2014. This provided the government with a source of funding and enabled the rapid expansion of the domestic IFS industry by establishing a pool of sharia-compliant liquid assets that can be held by Islamic financial institutions.

The CBB continues to offer sukuk according to a well-defined schedule: the Bahraini-dinar-denominated Al Salam sukuk is issued on a monthly basis, with a three-year maturity; the short-term Ijara sukuk, another dinar instrument, is also a monthly offering and has a tenor of six months; and the long-term dollar-denominated Ijara sukuk is issued on an ad hoc basis, and features tenors of 2-10 years.

As well as its regular offerings, Bahrain has shown its ability to overcome sovereign rating downgrades to raise substantial funds in the global markets. The kingdom’s sovereign debt offering of September 2017, which included a 7.5-year dollar benchmark sukuk, was met with high investor demand and an oversubscribed order book (see analysis).

Bahrain’s banks have also proved themselves capable of attracting investment over the past year. In June 2017 Al Baraka Banking Group announced the successful completion of a five-year sukuk at a rate of 7.875%. Issued on the mudaraba (profit-sharing and loss-bearing) model, the offer was five-times oversubscribed, attracting $1.6bn from GCC, Asian and European markets. The bank had initially targeted $300m, but due to the enthusiasm of the response this was raised to $400m. The funds raised by the perpetual sukuk are classifiable as Tier-1 capital according to the CBB’s implementation of Basel III rules, so the deal represents a useful broadening of the bank’s core capital base.

In September 2017 the kingdom’s oldest Islamic institution, Bahrain Islamic Bank, closed a syndicated murabaha (cost-plus financing) facility, which it aims to use for general funding purposes. The initial target of the facility was $50m, but following strong interest from the market the bank decided to use the significant oversubscription to raise this to $101m. Institutions from the GCC and beyond participated in the deal, including Bank ABC Islamic, Boubyan Bank, Dubai Islamic Bank, Emirates Islamic, Sharjah Islamic Bank, the National Bank of Ras Al Khaimah, the Islamic Corporation for the Development of the Private Sector, and two funds run by US-based fund specialist Federated Investors.

ISLAMIC BOURSE: While institutional investors have historically driven sharia-compliant investment activity in the kingdom, recent years have seen increasingly broad participation.

Since January 2015 individual retail investors have been able to subscribe directly in government sukuk and bond issuances on the Bahrain Bourse (BHB). The new mechanism, which was developed by the BHB and the CBB, allows domestic and foreign individuals and companies to partake through registered brokers, and thereafter trade the securities on the secondary market at the BHB.

In order to encourage greater participation by retail investors, the BHB established a low minimum subscription rate of BD500 ($1330) for 500 bonds, issued at a par value of BD1 ($2.65) each. The new mechanism has both broadened exchange activity and established a useful route to sharia-compliant yield for the investment community.

Other changes on the bourse have made it easier for investors to identify and direct capital to sharia-compliant instruments. In September 2015 the BHB authorities introduced the Bahrain Islamic Index, a standardised tool which tracks listed stocks that are compliant with the principles of sharia. The index’s 15 components illustrate Bahrain’s status as a regional IFS centre, and include some of the kingdom’s best-known institutions, such as Aluminium Bahrain, Al Baraka Banking Group, Bahrain Islamic Bank and Zain Bahrain. The composition of the index is reviewed periodically by a specialised board, which implements a template of technical, financial and sharia standards in its assessment process.

REGULATION: Much of Bahrain’s success in establishing itself as a global IFS centre rests on its early adoption of dedicated regulation for sharia-compliant financial activity. The CBB was the first regulator in the region to implement the Islamic window concept, by which conventional banks are permitted to undertake Islamic banking activities using their existing infrastructure. It was also the first to develop and implement regulations specific to the Islamic banking industry, a decision which has helped form its reputation for operating one of the most progressive regulatory frameworks in the GCC.

The central pillar of this structure is the CBB Rulebook, the six volumes of which cover conventional banks, Islamic banks, insurance licences, investment firm licences, specialised licences and capital markets. The regulator has made the AAOIFI standards of sharia-compliance mandatory for all Islamic institutions, and has developed a range of rules covering capitalisation, risk management, financial crime and disclosure, which take into account the particular needs of Islamic banking and insurance.

In some cases, these differ from the approach recommended by the Basel Committee on Banking Supervision and the Islamic Financial Services Board – the two standards that guide the development of the wider financial services sector. For example, while the capital adequacy requirement for the conventional sector is 8%, the ratio for Islamic banks is calculated by using a more complex formula, which takes into account variables including credit risk, market risk, operational risk and other factors, such as unrestricted profit-sharing investment accounts.

Islamic banks are subject to additional disclosure and governance rules aimed at providing assurance to stakeholders that they are complying with the principles of sharia. Beyond the CBB Rulebook, Islamic banks in Bahrain are also governed by several pieces of national legislation, including the Central Bank of Bahrain and Financial Institutions Law of 2006, the Bahrain Stock Exchange Law of 1987, and the Bahrain Anti-Money Laundering Law of 2001.

Day-to-day supervision of IFS is undertaken by the CBB’s Islamic Financial Institutions Supervision Directorate (IFISD), which follows a similar programme to that applied to the conventional sector. This includes meetings with Islamic banks to discuss prudential criteria, and the carrying out of annual reviews in which the IFISD assesses the institution’s financial report before it goes to its board.

OPERATIONAL & SOLVENCY FRAMEWORK: For takaful operators, the capital framework has historically been the same as that applied to their conventional counterparts, with the solvency of each fund operated by a takaful company assessed as if it were a separate licensed insurance firm. However, in 2014 the CBB introduced the Operational and Solvency Framework for the Takaful and Retakaful Industry, which addresses a number of issues that are particular to sharia-compliant insurance.

The most significant innovation of the framework is the prohibition of qard al hasan (interest-free loans) from the shareholders’ funds to cover any regulatory shortfalls in the policyholders’ funds. While this practice had proved useful to takaful operators seeking to mitigate temporary fluctuations in policyholders’ contributions, the CBB considered qard al hasan a solvency risk. The new framework also introduces a requirement for high-quality liquid assets, similar to Basel III rules for banks.

CONTINUED EVOLUTION: As one of the most proactive regulators in the region, the CBB continues to refine its approach to the IFS sector. It does so through regular updates to its rulebook, as well as the issuance of ad hoc notifications.

Recent innovations include a liquidity tool created by the IIFM to establish a one-week Islamic deposit facility based on the wakalah (contract of agency) model. This allows the regulator to accept deposits from Islamic banks and place them for seven days in an investment portfolio containing sukuk, allocated in advance by the parties.

In 2017 Bahrain also announced details of a reformed regulatory framework, which is expected to significantly enhance the levels of governance and transparency in the sector. After consulting with participants from the IFS industry, in September 2017 a series of revisions were revealed, which will come into effect in June 2018. From that time, Islamic banks in Bahrain will undergo an independent external sharia-compliance audit, a development which effectively ends the primacy of the banks’ proprietary sharia boards.

Banks’ sharia boards will also be compelled to make their rulings on products and services available to the public, by publishing them online and in the institution’s annual report – an important advance in governance and transparency.

The new framework strikes a compromise between the largely self-regulating model historically applied to questions relating to sharia-compliance and a centralised sharia board, which has been a topic of industry discussion since 2014 (see analysis).

OUTLOOK: The new regulatory requirements have been broadly welcomed by the industry and deemed “credit positive” by some of the leading credit ratings agencies. Their implementation in 2018, however, comes at a challenging time for the IFS sector. The ability of Islamic banks and insurance providers to expand their assets is impeded by a slow-growth environment engendered by subdued oil prices. Fiscal austerity measures being taken by governments around the GCC present a further obstacle to an industry that is heavily exposed to the region.

Nevertheless, the domestic economy continues to expand: the Bahrain Economic Development Board foresees GDP growth of 3.3% in 2018. The prospects for IFS sector growth are also buoyed by the goals of the kingdom’s development plan, Bahrain Economic Vision 2030. Among the capital-intensive projects emerging from the plan are the enhancement of rail infrastructure, the construction of a new causeway between Bahrain and Saudi Arabia, and the expansion of Bahrain International Airport. The kingdom’s well-capitalised Islamic banks, as well as the broader IFS industry which has developed around them, are well positioned to take advantage of the new opportunities that projects like these present.