Bahrain strengthening Islamic finance industry through new reforms

In light of its history as a regional financial hub, and the presence in the country of several major international Islamic financial institutions and support bodies, Bahrain has a well-developed, sharia-compliant financial services sector. The Islamic banking and takaful (Islamic insurance) segments have been posting healthy growth in recent years, though profit margins in each are under greater pressure than in their conventional counterparts. Both segments are also witnessing a trend towards consolidation, which industry players say should help create stronger institutions better able to invest in expansion and technological development.

Structure & Performance

Bahrain’s banking and insurance market, as well as its stock exchange, are overseen by the Central Bank of Bahrain (CBB), though the bourse is in the process of taking over some of the regulatory functions for which the CBB is currently responsible, leading it to effectively regulate itself in some domains (see Capital Markets chapter).

The kingdom is a major global centre for the Islamic finance segment, and is home to four such standard-setting institutions and infrastructure providers, namely the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), the Islamic International Rating Agency, the International Islamic Financial Market (IIM), and the General Council for Islamic Banks and Financial Institutions.

The value of the aggregated balance sheet of Islamic banks in Bahrain was $27.81bn at the end of November 2018, according to figures from the CBB. This represented 14.3% of total banking system assets at the time. Assets were up 4% from $26.75bn at the end of 2017, and 72.5% of the total were domestic assets.

Margins in the sector are tight: return on assets for Islamic retail banks stood at 0.2% in March 2018 – up from 0.1% six months prior – and return on equity at 1.5%, up from 1.1%, according to the September 2018 “Financial Stability Report” by the CBB. These compared to figures of 0.6% and 4.1%, respectively, for locally incorporated conventional retail banks, likely reflecting factors such as higher costs at Islamic banks and the conventional segment’s greater economies of scale.

The six months to March 2018 saw a slight deterioration in soundness indicators at Islamic banks in the kingdom. Non-performing facilities increased by one percentage point over the period to 10% of total facilities, driven in part by an 8.2-percentage-point increase in the value of non-performing loans (NPLs) to construction firms, reaching 27.6%, the highest level of any industry, and a 15.5-percentage-point rise in transport sector NPLs, the biggest jump of any sector. Meanwhile, the segment’s capital adequacy ratio fell from 18.2% in September 2017 to 18% in March 2018, and Tier 1 capital adequacy from 15.3% to 14.8%. Nevertheless, these figures remain comfortably above regulatory requirements, and liquid assets rose from 11.5% of total assets to 14.5% over the same period.

Regulatory Policy

Omar Mustafa Ansari, deputy secretary-general of the AAOIFI, told OBG that the Bahraini authorities have historically taken a proactive approach towards developing and regulating the unique segment. “From early on Bahrain worked to distinguish Islamic from conventional banking, something not all major markets did, and as a result emerged as a hub for Islamic financial services – a status it has worked to maintain,” he said.

In recent years the Islamic banking segment has seen several changes to its regulatory framework. Prominent among these was the implementation in June 2018 of a new sharia governance module that had been published by the CBB the previous September. The central bank expects the reforms to “result in a paradigm shift in improving the sharia compliance and governance standards among Islamic banks” in the kingdom. Changes under the governance module include new compulsory requirements for independent external sharia compliance audits. The central bank will begin publishing a report based on such audits from 2020 onwards. The audits form one of four elements of sharia governance specified by the module, the other three being a sharia supervisory board, a sharia coordination and implementation function, and an internal sharia audit function.

January 2018 saw Bahrain implement International Financial Regulatory Standard 9 (IFRS 9), an accounting standard that effectively requires all banks to provision for a percentage of loans that are expected to turn bad, in addition to those already formally classified as non-performing (see Banking chapter). Islamic banks were further required to apply a similar rule issued by the AAOIFI that was due to come into effect in 2020; however, the CBB asked all Islamic banks to adopt this on January 1, 2018 alongside IFRS 9.

In November 2018 the CBB announced that it was considering whether or not to extend recent regulatory reforms in the segment to the Islamic windows of conventional banks. The body also reported it was debating the development of a benchmark interest rate for the sharia-compliant segment.

In addition to regulatory changes, the CBB has taken various other steps in recent years to support the development of the segment. For example, in order to mop up excess liquidity, in 2017 the central bank introduced a new wakala (agency) investment tool based on a standardised model developed by the IIM that allows local retail sharia-compliant banks to invest excess liquidity with the central bank on a weekly basis. The CBB in turn invests the funds in a portfolio comprising international sukuk (Islamic bonds) and cash.

Market Breakdown

The largest purely Islamic bank operating in the kingdom is Al Baraka Bank Group, with assets of $24.6bn as of June 2018 and a net income of $121.8m for the first half of the year. The institution is the fourth-largest player in the banking sector when including conventional banks. Al Baraka is effectively controlled by Saudi businessman Saleh Kamel, who holds a direct equity stake of 30.11%. Dallah Al Baraka Group, of which Kamel is the founder and chairman, holds 24.6% of the group, and the asset management arm of Dallah Al Baraka has a further 19.3%. Shares in the group also float on the Bahrain Bourse. In addition to leading the local market, Al Baraka is a major player in the international Islamic banking arena, with subsidiaries and representative offices in 16 countries, and an international network of more than 700 branches.

Next is Ithmaar Bank, which held assets of BD3.25bn ($8.6bn) at the end of the second quarter of 2018 and recorded net income of BD3.61m ($9.6m). The largest shareholders in the institution are the Dar Al Maal Al Islaami Trust, with a 26.08% stake, and the Islamic Investment Company of the Gulf, at 19.6%, both of which are registered in the Bahamas. No other shareholder holds more than a 5% stake in the institution, shares of which also trade on the local bourse.

In third is Al Salam Bank, with assets of BD1.62bn ($4.3bn) and first-half 2018 net income of BD9.42m ($25m). The bank’s largest shareholder is Omani institution Bank Muscat, having a stake of 14.74%. No other shareholder holds a stake of larger than 10% in Al Salam, and it shares again trade on the Bahrain Bourse.

Consolidation

The market may soon see a new leader, however, due to a proposed merger between Bahrain’s largest bank by assets, Ahli United Bank, and Kuwaiti sharia-compliant institution Kuwait Finance House. Although Ahli United is a conventional bank, the resulting company would likely be an Islamic entity, meaning that Bahrain’s largest bank would be sharia compliant. Formal merger talks between the two began in July 2018 when investment banks HSBC and Credit Suisse were chosen to begin valuations.

The proposed transaction is part of a wider wave of consolidation efforts under way in the region, with a notable example being the 2017 merger of Abu Dhabi’s two largest banks. Back in the local market, National Bank of Bahrain (NBB) was reported in October 2018 to be considering acquiring a further stake in local Islamic lender Bahrain Islamic Bank (BIB). Further details were not made available, but two months earlier the NBB was in negotiations to acquire the Islamic Development Bank’s 14.4% equity stake in BIB, which would take NBB’s holding in the bank to 43.5%.

The CBB is supportive of such consolidation, which it believes will give rise to stronger institutions that are better able to cope with increasing sectoral regulatory requirements (see Banking chapter).

Conventional Banks

The value of assets held by Islamic windows of conventional banks stood at BD1.47bn ($3.9bn) at the end of November 2018, according to CBB figures. This was up slightly from BD1.46bn ($3.6bn) one year prior and BD1.42bn ($3.87bn) at the end of 2017. Roughly 60% of the November 2018 total was domestic assets.

Many major conventional banks in the kingdom offer Islamic services. For example, Ahli United Bank provides such services under its Al Hilal brand. The kingdom’s second-largest bank, Arab Banking Corporation, operates a sharia-compliant subsidiary named ABC Islamic, which had assets of $27.9bn in September 2018. Bahrain’s third-largest bank, Saudi government-owned Gulf International Bank, recently launched a new sharia-compliant digital bank called Meem (see analysis).

Sharia-Compliant Lending

In borrowing activity, the largest category for Islamic retail banks is personal and consumer finance, accounting for 19.8% of total lending as of March 2018. Next was the financial sector at 16%, followed by commercial real estate financing and the manufacturing industry, both with 12.1%. Residential mortgage lending stood in fifth place (10.4%).

Murabaha loans are the most popular Islamic lending product, capturing 63.1% of the segment as of March 2018, and ijara leasing loans followed in second place, at 21.7%. Murabaha is a type of cost-plus financing, where interest is not charged on the loan, but an agreed amount is paid that comprises the cost of the product plus a profit to its previous owner. With ijara loans, rental payments of an agreed amount and duration are made until ownership is transferred upon completion of the payments.

Funds & Indices

Of the 80 locally incorporated investment funds active in the kingdom as of March 2018, 33 were Islamic funds, according to the CBB. These comprised 29 Islamic collective investment unit funds and four private investment unit funds. The net asset value of Islamic funds, including onshore and offshore funds, stood at $1.43bn, equal to 19.2% of the net asset value of the kingdom’s entire fund industry.

In addition to its all-share and sectoral indices, the Bahrain Bourse stock exchange launched an Islamic Index in September 2015. As of December 2018, 13 sharia-compliant equities were listed on the market. The index is dominated by financial services equities, but also includes shares in firms of other sectors such as real estate development and food production.

The index underperformed the Bahrain All-share Index (BASI) in 2018: in mid-December it was down about 21% for the year, compared to a fairly flat performance for the BASI. Moreover, the index was down approximately 10% compared to its first week in 2015.

Takaful

Many of those who participate in Islamic banking services opt for Islamic insurance as well. Total gross takaful premium were worth BD60.43m ($160.1m) in 2016, according to the CBB’s last “Insurance Market Review”. This represented 22.2% of total national gross insurance premium that year, and was down by 4.4% on 2015. However, growth appears to have returned since then: in the first three quarters of 2017 gross premium were worth BD45.7m ($121.1m), up 12.3% year-on-year (y-o-y).

Although full-year data was not available for 2017 at the time of publication, premium grew even faster in the first quarter of 2018 – the latest data from the CBB’s twice-yearly financial stability report – to BD21.4m ($56.7m). This was up 25.8% on the same time one year earlier, and equivalent to 26.1% of total gross insurance premium in the kingdom.

Yahya Nooruddin, CEO of t’azur Islamic Insurance and chairman of the Bahrain Insurance Association, told OBG that competition in the local insurance market was based on pricing above any other factor, and that takaful did not have a particular competitive advantage, especially regarding personal lines – though he noted that some institutions were obliged to use Islamic insurers. However, Nooruddin said that the segment’s smaller base was helping to support faster growth compared to conventional insurers.

Net profit after taxes in the segment stood at BD1.07m ($2.8m) in the first quarter of 2018, down 5.6% from a year earlier. This represented 11.7% of total insurance industry profits, substantially below the segment’s share of premium, suggesting that takaful firms are less profitable than conventional operators.

Insurance Players

According to comprehensive market data from the central bank for 2016, Takaful International was the largest of six players operating in the segment, on gross premium of BD19.64m ($52m). In April 2017 Bahrain Kuwait Insurance Company – which is majority owned by the Gulf Insurance Group, a joint venture between Kuwait Projects Company and Canada’s Fairfax Financial Holdings – increased its equity stake in the company from 40.9% to a majority holding of some 67.8%, and subsequently converted Takaful International into a subsidiary.

However, BKIC, which reported gross contributions of BD19.7m ($52.2m) in 2017, has been overtaken as market leader by new player Solidarity Bahrain. The latter was created in December 2017 through a merger between mid-ranking takaful provider Solidarity General Takaful and conventional fellow mid-sized player Al Ahlia Insurance Company. The merged entity is a takaful provider, with Solidarity having agreed on mechanisms regarding how to transition Ahlia’s portfolio to sharia-compliant status with the CBB. Abhijit Singh, assistant general manager for investments and special projects at Solidarity Bahrain, told OBG that no clients objected to the transition.

The combined premium of the two firms was equivalent to BD29.4m ($77.9m) in 2016 and BD30.6m ($81.1m) in 2017, effectively placing it ahead of the entire insurance market leader that year, conventional operator Bahrain-Kuwait Insurance Company, which reported gross premium of BD26.2m ($69.4m). Prior to the merger, Solidarity General Takaful posted premium of BD15.88m ($42.1m) in 2016.

Speaking in September 2018, Singh said the merged entity was doing well. “You often do not see great results from mergers and acquisitions in the first year, but that has not been the case here – the company showed good profitability in the first half of the year and is on track to meet our target of at least 10% return on equity for the whole year,” he told OBG.

The third-largest player based on the 2016 rankings was t’azur Company, with premium of BD14.18m ($37.6m). The firm was founded by Unicorn Investment Bank and is owned by Bahrain’s Bank Al Khair, as well as by investors in Saudi Arabia, Kuwait and Qatar.

Nooruddin said that he hoped the merger between Solidarity and Al Ahlia was a sign of a wider trend towards consolidation in the local insurance market. “At the moment there are too many players, and without consolidation, companies will not be able to keep up with industry trends, invest in new technology and cope with the imposition of value-added tax,” he told OBG. While he said he was not aware of any further planned transactions, he believed more mergers were likely and that the Bahrain Insurance Association was seeking to encourage them. “We will not force anyone to merge, but we would like to see more consolidation to create stronger companies,” he added.

Takaful Subsectors

The largest line of takaful business is medical insurance, gross premium for which stood at BD8.52m ($22.6m) in the first quarter of 2018, equivalent to 39.9% of total sharia-compliant premium. Premium for the segment were up 38.6% y-o-y, meaning that medical takaful accounted for nearly half (48%) of total takaful premium growth over the period.

The line is likely to witness further robust growth in the coming years, in light of the May 2018 passing of a new law mandating that private employers provide all of their expatriate employees with health insurance. Industry figures estimate that the reforms could bring as many as 300,000 new insurance customers into the market (see Insurance chapter).

The second-largest takaful category is motor insurance, with premium of BD6.42m ($17m) as of March 2018. This was up from BD4.53m ($12m) one year earlier, representing growth of 41.7%. The next-most productive line is fire, property and liability insurance, premium of which were worth BD2.32m ($6.1m), more or less unchanged from BD2.36m ($6.3m) a year prior.

Family Takaful

Long-term – or life – premium stood at just BD1.46m ($3.9m) in March 2018, down from BD1.93m ($5.1m) in March 2017. Singh told OBG that takaful firms were at a disadvantage when it came to selling life insurance (known as family insurance) due to a lack of sharia-compliant investment products. “Conventional firms can offer around 5000 funds, but there are not a lot of managers in the takaful segment with good pedigree whose products you can link to your risk product,” he said, noting that Solidarity Bahrain had previously operated a standalone family takaful firm, but closed it due to lower-than-anticipated growth. “There is also an effective lack of tax incentives for life insurance in general, which helps to drive savings elsewhere, given no income tax,” he added.

Re-Takaful

There are two locally incorporated re-takaful firms in the kingdom, which is comparable to reinsurance. Gross re-takaful premium stood at BD60.7m ($160.8m) in 2016, representing 16% of gross reinsurance premium in Bahrain that year. The value of such premium was down 27.2% on 2015 figures, while the value of conventional reinsurance gross premium grew by a slight 1.3% in 2016.

Despite the presence of local providers, the availability of sharia-compliant reinsurance is limited. “The main challenge for takaful firms at the moment is a lack of re-takaful capacity in the region, which obliges companies to take on some conventional reinsurance,” Nooruddin explained to OBG.

Singh echoed this sentiment. “If you want a diversified panel of reinsurance with high ratings – say ‘A-’ or above – you will not be able to obtain re-takaful,” he said. “However, most sharia boards are aware of the challenge and we have consistently been able to obtain exemptions; furthermore, availability is improving and even conventional reinsurance providers are coming up with re-takaful windows.” Ansari said the issue was a common one in the industry. “The biggest problem when Islamic insurance takes off in any country is the availability of re-takaful,” he told OBG. “The reinsurance business is highly specialised and not many firms want to enter it. However, demand will stimulate supply and once the sector becomes large enough, re-takaful and other solutions will emerge.”

Regulations

The most recent major regulatory change in the local Islamic insurance segment occurred in 2014, when the CBB put in place a revised version of its operational and solvency framework for the takaful and re-takaful insurance industry.

The primary reform under the new rules was a change to the basis for calculations regarding the extent to which companies were meeting capital requirements, following persistent deficits in participants’ funds, largely as a result of capital shortfalls.

The CBB, in its September 2018 “Financial Stability Report”, reported that it continues to review returns from takaful firms and that the new rules appear to have helped give rise to positive financial results in recent years. As of September 2018 the central bank was in the process of updating other regulatory requirements for Islamic insurance providers, with changes to include the introduction of new minimum training and qualification requirements for some heads of function, including company CEOs.

Sukuk Market

Sharia-compliant finance extends to investment as well, and in March 2018 the government issued a $1bn sukuk with a tenor of seven and a half years – its most recent international debt issue. Officials received orders for around twice the value of the issue, which offered a yield of 6.875%.

Of the 15 debt instruments listed on the Bahrain Bourse as of December 2018, five were sukuk. Four of these are government ijara sukuk, with a combined value of BD675m ($1.8bn). The other is a $100m sukuk issue by the Investment Dar Company, a Kuwaiti Islamic consumer finance provider.

The CBB also issues short-term sukuk as part of its treasury bill programme on behalf of the government on a monthly basis. The most recent issues at year-end 2018 were a sale of BD26m ($68.9m) worth of sukuk ijara, with a tenor of 182 days and an expected return of 4.45%, and a BD43m ($113.9m) issue of 91-day sukuk al salam, with an expected return of 4.27%, both of which took place in mid-December.

Outlook

The recovery witnessed in the global oil price in the first half of 2018 looked set to bolster the Bahraini economy, and by extension its financial services sector, but the sharp fall in the final months of the year have diminished such hopes. Nevertheless, there is cause for optimism as the authorities take on a proactive approach. Recent regulatory reforms and consolidation in both the Islamic banking and takaful segments, as well as the boost Islamic insurers should receive from the new medical insurance requirement, look set to support sector growth in the near future.