Bahrain combats declining banking sector growth with regulator vigilance

Bahrain’s banking sector has managed two years of a challenging low oil price environment without seeing significant deterioration in its key financial stability indicators. Both conventional lenders and Islamic financiers operating within the kingdom’s robust regulatory framework have also managed to maintain profitability throughout this period thanks to efficiency drives and continued government spending on large infrastructure projects.

However, with the kingdom’s banking industry and the wider economy facing a third successive year of low oil prices, efforts to maintain growth margins are becoming more challenging.

SECTOR MILESTONE: Bahrain’s banking sector marks an important anniversary in 2017. It was a hundred years ago that a Mr Macfill, the representative of the UK-owned and India-headquartered Oriental Bank, met with Bahrain’s ruler at that time, Sheikh Isa bin Ali Al Khalifa, to discuss an interesting development. At the top of the agenda was a proposed plan for the Oriental Bank to open a branch in Manama, for which it had received approval from the British authorities in 1916.

The arrival of the bank in Bahrain represented an important economic advance, bringing a heightened level of formality to a sector which had up to that point been operated on an unregulated basis, and was primarily constituted by local traders renting out space in their safes to pearl traders.

The establishment of the bank was not without its challenges, however, which ranged from locating a suitable property to objections from the traders who had profited from the previously informal financial environment. It was not until July 1920 that the Oriental Bank opened its doors for business in Manama, ushering in a century of banking sector growth and establishing the kingdom as an early adopter of modern financial services in the region. For the first decades of its development the industry was populated entirely by foreign institutions, but in 1957 a domestic lender entered the market in the form of National Bank of Bahrain (NBB), which still plays a prominent role in the market today.

Bahrain’s status as a regional financial centre received a boost in the 1970s with an influx of Lebanese institutions to Manama in the wake of growing unrest in their home market. The result was the genesis of a vibrant community of banking professionals, the collective expertise of which helped the kingdom to gain an early lead in establishing itself as a banking hub for the region.

More recently, the emergence of other commercial centres in the Gulf, such as Doha and Dubai, has brought a heightened level of competition for regional assets, but in this market Bahrain retains a number of advantages, most notably 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.

TODAY’S MARKET: In regulatory terms, Bahrain’s modern banking sector is divided into retail and wholesale segments — which are further defined as either Islamic or conventional — with numerous institutions holding multiple licence types. As of November 2016 the Central Bank of Bahrain (CBB) register recorded 22 conventional retail banks, seven of which were locally incorporated and 15 of which were headquartered abroad.

Bahrain’s local retail banking segment is dominated by three players that run branch networks considerably larger than their colleagues: NBB, with 28 branches; BBK, formerly known as Bank of Bahrain and Kuwait, with 24 branches; and Ahli United Bank (AUB), with 20 branches. Other retail banks operating in the kingdom – such as France’s BNP Paribas, the UK’s HSBC and the US-based Citibank – maintain networks of between two and six branches or, in some cases, conduct their business from a single head office.

It is the regionally focused wholesale banking segment, however, that accounts for much of Bahrain’s reputation as a global financial hub. As of October 2016 the CBB had issued licences to 57 conventional wholesale banks, including locally incorporated players such as Arab Banking Corporation, 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 a variety of global operators, such as Pakistan’s Allied Bank, India’s Bank of Baroda, the Philippines’ Allied Banking Corporation, Finansbank, Denizbank and Türk Economi Bankası of Turkey, and JP Morgan from the US.

ISLAMIC BANKING: Lastly, since the 1980s Bahrain’s banking sector has contained a growing number of sharia-compliant institutions. Currently, around 29% of Bahrain’s total banking sector assets are accounted for by its vibrant Islamic banking industry, according to global financial services firm EY.

As of October 2016, some 25 Islamic banks were licensed to operate in the kingdom, all but three of which – Kuveyt Türk Katılım Bankası, Türkiye Finans Katılım Bankası and the sector’s most recent arrival, Sudan’s Bank of Khartoum International – were locally incorporated. Like conventional banks, sharia-compliant banks are licensed either to operate as retail institutions or wholesale operators (see Islamic Financial Services chapter).

At the end of 2016 the governor of the CBB, Rasheed Mohammed Al Maraj, repeated calls for the country’s Islamic lenders to consider engaging in a round of mergers or acquisitions to hone their competitive edge in the market and help cement the country’s position as one of the world’s leading sharia-compliant financial centres. Gulf Financial House (GFH), a regional sharia-compliant lender, is already in the process of acquiring Bahraini lending Bank Alkhair, according to GFH’s CEO, Hisham Al Rayes. The sale should be concluded some time in the first quarter of 2017, he told Reuters in December 2016.

THE BIG FIVE: The structural variety exhibited by the kingdom’s largest locally incorporated lenders reflects the diversity of the sector. The “big five” of Bahrain banks by total assets is made up of both conventional and Islamic institutions, banking groups with an international focus and national players that have built their balance books by concentrating their efforts on the Bahraini economy.

The largest of them, which had assets of $35.8bn as of September 2016, is the Ahli United Bank Group, the flagship of which is the AUB. Established in 2000 with the merger of The United Bank of Kuwait and Al Ahli Commercial Bank, it operates in the local market under a retail licence, but its network of subsidiaries and associated companies provide it with corporate, private and Islamic banking capacity across a number of regions, including the UK, Egypt, Kuwait and Iraq. It provides its sharia-compliant services, meanwhile, through the Al Hilal Bank brand name.

The bank’s strategy is centred on expansion within the GCC and MENA regions, and to that end in October 2016 its Kuwait subsidiary successfully completed a $200m issue of a Basel III-compliant perpetual additional tier-1 sukuk (Islamic bond).

Other recent advances by AUB include launching a new wholly owned subsidiary in the Dubai International Financial Centre, increasing ownership of its insurance joint venture to 100%, the full conversion of its Libyan affiliate to a sharia-compliant bank, adding to the paid-up capital in AUB’s Egyptian subsidiary despite a challenging environment.

With total assets of $33bn in June 2016, Bank ABC – formerly the Arab Banking Corporation – is the nation’s second-largest lender. Established in 1980, its footprint now spreads across 21 countries worldwide – namely, Algeria, Bahrain, Brazil, France, Germany, Iran, Iraq, Egypt, Lebanon, Italy, Jordan, Singapore, Sweden, Tunisia, Turkey, Libya, the UAE, the UK, Grand Cayman, Russia and the US.

Beyond its retail banking operations, it has established itself as a market leader in trade finance, treasury, project and structured finance, syndications, corporate and institutional banking, and Islamic banking, which it conducts through its sharia-compliant arm, Bank ABC Islamic.

The bank’s current expansion strategy is built around growing its principal banking franchises in the MENA region and Brazil while undertaking a major recruitment drive of senior bankers as a means to stimulate growth (see analysis).

Al Baraka Banking Group, with total assets of $25bn in June 2016, is the third-largest bank in Bahrain and the largest sharia-compliant operator. Its footprint encompasses 15 countries in the form of subsidiary banking units – including Jordan Islamic Bank, Al Baraka Bank Pakistan, Banque Al Baraka d’Algérie, Al Baraka Bank Sudan, Al Baraka Bank South Africa, Al Baraka Bank Lebanon, Al Baraka Bank Tunisia, Al Baraka Bank Egypt, Al Baraka Turk Participation Bank, Al Baraka Bank Syria and representative offices in Indonesia and Libya.

While components of the group date back to 1978, the current group was formed in 2002 and underwent its initial public offering in 2006. Since that time it has sought disparate opportunities in key markets that are non-correlative, and therefore represent, according to the bank’s strategy statement, a natural method of risk diversification.

RECENT MOVES: The bank announced in 2015 that it planned to almost double its assets to $46bn over the subsequent five years by expanding into markets such as Morocco, Indonesia and China. In January 2017 Al Baraka announced that the central bank of Morocco, Bank Al Maghrib, had granted it permission to commence operations in the country.

Al Baraka Morocco is to be formed in partnership with BMCE Bank, one of the oldest and commercial private banks in the Moroccan banking industry. This development means that as of later in 2017 the bank will have established a presence in all of the countries of the Maghreb region.

The fourth-largest lender in the kingdom is Gulf International Bank (GIB), which in June 2016 held assets of $23.3bn. The bank is known for its strong corporate balance sheet, much of which is attributable to its branches in Riyadh and Jeddah. Its access to the Saudi market is further enhanced by the fact that Saudi Arabia’s Public Investment Fund maintains a 97.2% stake in the institution.

GIB’s principal subsidiary is GIB (UK), which focuses on asset management and investment banking activities. It also operates dealing rooms in Bahrain, London and Dharan, from which it carries out portfolio trading, hedging and investment operations, and investment in specialised markets through external fund managers.

Since 2010 the bank has begun to expand from this corporate and investment banking base by adopting a new strategy aimed at establishing the bank as a universal GCC institution, operating across the core areas of corporate banking — investment banking, asset management and retail banking.

To this end, GIB has attained a retail banking licence in Saudi Arabia, and has applied for more retail licences in other jurisdictions in the GCC region. It has opted to base its Saudi retail expansion on a digital platform, supported by three branches in Dhahran, Riyadh and Jeddah, as well as a network of so-called nano-stores to facilitate customer acquisition. Attracting retail deposits will provide the bank with a more stable funding base, and the digital model being established in Saudi Arabia will in time be rolled out across the region. BBK, with assets of $9.9bn as of June 2016, is the largest of the domestic banks, with a predominantly local focus. Established in 1971, it is best known in Bahrain for its pioneering of the “Financial Mall” model, which saw it establish a number of retail-focused centres offering services such as credit card partners, telecommunication operators, personal finance advisors and insurance providers under one roof. In 2016 the bank opened its 17th branch in Bahrain and appointed a new chief executive, Reyadh Yousif Sater, who previously was the deputy chief executive of the bank’s business group.

Beyond its retail activities, BBK offers lending, treasury and investment services to the corporate sector in Bahrain and to businesses beyond the local market through operations in Kuwait, India, Dubai and, most recently, Turkey. Its Istanbul representative office was officially inaugurated in January 2017, and is intended to allow the bank to liaise with existing and prospective clients in the country, as well as monitoring local market developments and dealing directly with the Turkish authorities.

CHANGES AT THE TOP: The bank has also begun to broaden its product range and build crossover business by establishing subsidiaries in the areas of financial services, Islamic investment, mortgages and credit cards. In January 2017 BBK announced a number of new executive appointments as part of a wide-ranging reorganising plan.

The changes brought new personnel into a range of banking units, including a new deputy chief executive, as well as heads of wholesale, retail, information technology, financial planning and control, and treasury and investment. The new management team is charged with implementing the remainder of a three-year strategy (2016-18).

Lastly, while total assets of $7.9bn place the NBB outside the big five, the domestically focused bank plays an important role in the local economy. Founded in 1957, it operates the largest branch network in the kingdom, with 26 outlets. It has played a central part in the economic development of the nation, and its ownership structure includes some of Bahrain’s most important institutions – including what is effectively the government’s investment arm, the Bahrain Mumtalakat Holding Company, which has a 45% stake in NBB.

The bank is also the biggest shareholder in Bahrain Islamic Bank, which has just embarked on a five-year plan to boost growth that will see it dispose of non-core investments and seek to establish an annual revenue growth rate of between 20% and 25%. NBB commences the 2017 financial year under new leadership, following the announcement in late 2016 that Jean-Christophe Durand will become its new CEO. Durand comes to NBB from BNP Paribas, where he was head of corporate and institutional banking for the Middle East and Africa.

PERFORMANCE: The fact that most Bahraini banks serve a number of global markets helps the industry to maintain steady growth rates, even during economically challenging periods.

For example, over the course of the politically eventful year of 2011, aggregate annual asset growth reached 2.6%, lending growth hit 14.9%, and deposit growth registered a 10.1% rise, according to CBB data. The retail segment has shown particularly robust growth over the past decade, its assets expanding from BD18.6bn ($49.3bn) in 2007 to BD31.22bn ($82.8bn) in the first quarter of 2016, according to the CBB. Since 2014, this expansion has been driven by domestic asset growth, which accounts for approximately 54.3% of the total.

Despite maintaining profitability, the wholesale segment has reduced its aggregate assets over the same period, from 8.1 times GDP in 2010 to 3.38 times GDP during the first quarter of 2016. This trend can be explained by the exposure of the wholesale segment to the GCC and European markets, which are experiencing an extended period of muted growth that even the diversified loan books of the segment are struggling to counter.

However, because only around 8% of wholesale bank assets are derived from Bahrain, the contraction of the segment has not had a significant effect on the local economy. Since the decline of oil prices in the second half of 2014, Bahrain’s banking sector has been subject to a particularly challenging environment, characterised by a tightening fiscal policy and slowing private sector activity; a pattern that is repeating across the GCC.

Nevertheless, the banking sector showed a high degree of resilience in 2015 and 2016. An analysis of the kingdom’s five largest banks for the 2015 fiscal year shows that aggregate assets grew from $116.8bn at the close of 2014 to reach $119.7bn a year later, a rise of around 2.4%. Customer deposits and loans and advances, meanwhile, grew by 3.26% and 2.87%, respectively.

The combined net profit for the five lenders came in at $1.3bn, a modest slowdown of 1.16% on the previous year. The single largest percentage rise in net profits for the year was made by GIB, with its total income growing from $85.6m to $94.6m, or around 11%, followed by AUB and BBK, which both increased profits by 7% over the period. The banks’ strong performance continued into 2016, which saw Bahrain’s big five increase their total assets by 4% in the first half of the year, while posting a solid 3% growth in aggregate net profit.

SECTOR STABILITY: The low oil prices that have persisted throughout 2015 have focused attention on the banking systems across the region. While there is some concern across the GCC regarding deteriorating asset quality and exposure to vulnerable markets, the financial soundness indicators relating to the Bahraini industry have thus far proven encouraging. According to CBB data, the capital adequacy ratio for conventional retail and wholesale banks showed modest decreases by March 2016, to reach 18.1% and 19.4%, respectively, yet well in excess of the minimum required by the regulator.

Non-performing loans (NPL) for conventional retail and wholesale banks stood at 4% and 5.7%, respectively, in the first quarter of 2016, a relatively comfortable range close to the 2015 global average of 4.3%. For Islamic banks the picture is similar, with a capital adequacy ratio of 15.8% for retail institutions and 19.1% for wholesale financers. However, while wholesale sharia-compliant operators enjoyed a relatively small NPLL ratio of 4.9% in the first quarter of 2016, their retail counterparts exhibited a ratio of 12.4% – a consequence of their higher exposure to troubled real estate and construction projects in the region. As with most of the GCC region’s banking sector, the principal concern with regard to sector stability is the question of loan concentration. In aggregate, the domestic banking industry in the kingdom is particularly exposed to the real estate and energy sectors, both of which have been adversely affected by the decline in oil prices.

REGULATION: In 2017 the question of asset quality is therefore likely to be high on the agenda of the CBB, which oversees one of the most well-regarded regulatory frameworks in the region.

The main pillars of this framework are the Central Bank of Bahrain and Financial Institutions Law 2006, the Anti-Money Laundering Law of 2001 and the 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 and Islamic banks.

In the wake of the global economic crisis, the CBB has focused on ensuring that the banking sector is adequately protected from economic shocks, and to that end requires that all banks maintain a minimum capital adequacy ratio of 12%. This is further boosted by the application of a 0.5% Capital Conservation Buffer, also made up of Tier-1 capital. This compares favourably to the minimum solvency ratio of 6-8% established by Basel III regulations.

The formal and informal lines of communication between banks and the regulator remain strong in Bahrain, and the Central Bank of Bahrain and Financial Institutions Law 2006 requires that the regulator consult with the industry before issuing any new regulations, unless the regulation in question is urgently required.

BASEL RECOMMENDATIONS: In recent years, much of the dialogue between the CBB and stakeholders in the financial market has centred on the adoption of the Basel II and III regulations by the local banking industry. In 2015 the CBB introduced Basel’s liquidity coverage ratio, which will be gradually implemented until full compliance status is reached in 2019. The Basel regulations aim to ensure that banks have sufficient liquid assets to overcome a stress scenario for a duration of at least 30 days.

Other significant regulatory developments over the past two years include designating the banking sector’s systemically important domestic banks in accordance with Basel regulations, as well as the finalisation of Basel’s public disclosure rules for all conventional banks operating in the country.

In discussions with OBG, the CBB indicated that it is currently working on the issue of capital requirements for Islamic institutions. The regulator is also examining the area of customer protection: having already abolished fees for ATM withdrawals, in the second half of 2016 it was considering the introduction of fee caps – a decision that is likely to place further pressure on the margins of Bahrain’s banks.

In the medium term, it is likely that Bahrain’s sharia-compliant financers will be faced with an even more significant regulatory change in the form of a centralised sharia committee vested with the authority to approve products and services across the sector (see Islamic Financial Services chapter).

CYBERSECURITY: Allied to the customer protection issue is the subject of cybersecurity, which has recently become a point of strategic focus for the regulator. The 2016 data breaches suffered by leading banks in Qatar and the UAE’s Sharjah emirate, which included the theft of thousands of files containing passwords, PINs and payment data, have highlighted the risks associated with new technologies and increasing interconnectivity.

Financial technology (fintech) products and services are expanding rapidly in the GCC, and customers are eagerly adopting e-payment facilities across all bank channels, as well as those provided by other service providers, ranging from telecom, utilities, card schemes and transportation.

Providing attractive fintech solutions is central to both client acquisition and retention in the competitive markets of the GCC, but the advantages that new platforms and digital features bring to both banks and their clients are accompanied by an increased security risk which, given the fast-moving nature of this area of the market, presents a significant regulatory challenge.

In response, the CBB has overhauled its physical security requirements for ATMs and has informed banks that cybersecurity provisions will become part of their annual audits. The regulator has sought to further protect customer data by requiring the providers of ancillary financial services to obtain licences to operate in Bahrain, a decision which by September 2016 had resulted in the issuance of 10 licences. In October 2016 the CBB held a round-table discussion on cybersecurity at its Manama headquarters that explored best practices for data protection, cybertrends and other security measures that might be applied to the industry in Bahrain.

According to the CBB, these included the use of up-to-date antivirus software, limiting web usage in the office to business-related sites, management of different email accounts for different purposes and password protection hygiene. The CBB has earned a reputation for consistently keeping pace with international best practices, and therefore is likely to invest in remaining ahead of the curve on cybersecurity over the coming years.

OUTLOOK: Given that Bahrain’s banking sector is well-insulated against the challenges presented by low oil prices, the questions that will occupy industry observers in 2017 are likely to centre on system liquidity and the ability of banks to maintain their margins in a more costly funding environment.

While a drawdown of government deposits raised some liquidity concerns in 2016, the consequent rise in the interbank rate was a modest one (see analysis). The GCC banking sector is expected to show relatively muted growth between 2017 and 2020, with a Fitch Group Company BMI Research analysis forecasting a 6% annual expansion over the period.

This represents a significant slowdown on the average annual expansion of 17% seen over the past decade, which was fuelled by high oil prices and large government spending programmes. Within this contracting trend Bahrain’s banks are particularly vulnerable to the challenging economic environment, due to the relatively small size of the government’s reserves and the extent to which its commercial banks rely on public deposits.

Countering this is the ability of the government of Bahrain to maintain a substantial capital spending programme thanks to the Gulf Development Fund, a development finance vehicle established in 2011 by the GCC (see Economy chapter).

Opportunities arising from this spending programme include the credit requirements associated with the development of Bahrain National Airport and the upgrading of the nation’s refinery network, which are generating demand for long-tenor financing. Yet more opportunities are arising from the government’s attempts to address a housing shortage, which will require a substantial amount of large-scale investment for years to come.

Lastly, Bahrain is mulling over an institutional innovation which, if implemented, will further enhance the kingdom’s status as a country ahead of the legal and regulatory curve in the region. In late December 2016 the Bahrain Association of Banks revealed it was consulting with its members about the creation of the GCC’s first specialised banking court, the primary mission of which would be to resolve disputes arising from banking and financial transactions conducted in Bahrain.

The Bahrain Chamber for Dispute Resolution, an independent institution established in 2009 in partnership with the American Arbitration Association, has to date played an important role in settling banking disputes in the kingdom.

However, its remit is limited to cases that involve sums of more than $500,000. The introduction of a dedicated banking court that has the necessary expertise to resolve all cases in an efficient manner, regardless of the monetary value at stake, would therefore represent a significant step forward for the smooth operations of Bahrain’s banking sector.