Regulatory framework and consolidation support sharia-compliant offerings in Bahrain

As both a regional and global leader in Islamic finance, Bahrain benefits from supportive regulation, capable human resources, and a reputation for diversified and mature offerings. Demonstrating this, the Islamic banking and insurance segments have recorded elevated growth rates compared to their conventional counterparts in recent years, even as the industry faced macroeconomic headwinds.

Islamic banking assets continued on an upwards trajectory in 2018 and 2019, and banks are well positioned to implement new accounting standards despite some anticipated near-term pains. The takaful (Islamic insurance) segment is in the midst of a period of high-profile mergers and acquisitions (M&A), as conventional insurers seek inorganic growth and diversified business lines. This same trend is also seen in Islamic banking, where ongoing M&A deals between Islamic and conventional banks are expected to dramatically alter the landscape. Meanwhile, the sovereign sukuk (Islamic bond) market has benefitted significantly from a late-2018 agreement that saw Bahrain’s GCC neighbours provide $10bn in financing to the kingdom. Corporate sukuk could also be set for expansion as standard-setting agencies work to enact reforms emphasising asset-backed structures.

Structure & Oversight

Regulated by the Central Bank of Bahrain (CBB) in close collaboration with a number of standard-setting organisations headquartered in the kingdom, Bahrain’s Islamic finance sector has been a regional pioneer over the previous three decades. Owing in large part to a long history of proactive and innovative regulatory support, the kingdom has expanded the number of Islamic products and instruments available to include corporate and sovereign sukuk, musharaka (joint venture structures in which the partners share the profits and losses), murabaha (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), takaful and retakaful (Islamic reinsurance). An August 2018 paper by researchers from Istanbul Medeniyet University and Kocaeli University in Turkey found that Bahrain showcases “the region’s greatest applications of Islamic finance institutions active in every area of Islamic finance, such as asset management, sukuk issuance, and sharia-compliant insurance and reinsurance”.

CBB-regulated entities are supporting the central banks’ efforts to develop Islamic finance. In September 2015, for example, the Bahrain Bourse (BHB) launched the Bahrain Islamic Index, with 17 companies initially listed. The BHB enacted a number of technical and financial standards to determine companies’ sharia compliance and established a specialised committee that periodically reviews listed companies. As of October 2019 there were 14 companies listed on the Bahrain Islamic Index, which is dominated by equities of financial services companies but also includes shares in firms in the telecommunications, real estate and food production sectors.

Out of the 98 banks operating in the kingdom, 21 are dedicated Islamic institutions, with total assets of BD27.9bn ($74bn) as of December 2019. Islamic banks active in Bahrain include Ahli United Bank; Bank ABC Islamic, a subsidiary of the Arab Banking Corporation; Al Baraka Bank; Al Salam Bank; Bahrain Islamic Bank (BISB); Citi Islamic Investment Bank; Khaleeji Commercial Bank; Ithmaar Bank; Kuwait Finance House; Gulf Finance House Group; and Kuveyt Türk.

Standard Agencies

The sector’s depth, diversity and strength are attributable in part to the direction of numerous standard agencies that are headquartered in the capital, Manama. These organisations include the Bahrain Institute of Banking and Finance (BIBF), which was established in 1997; the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI); the General Council for Islamic Banks and Financial Institutions; the International Islamic Financial Market (IIFM); the Islamic International Rating Agency (IIRA); Deloitte’s Islamic Finance Knowledge Centre; and EY’s Islamic Banking Centre.

Previously known as the Financial Accounting Organisation for Islamic Banks and Financial Institutions, the AAOIFI was established in March 1991 as an international, autonomous, non-profit organisation. It is mandated to develop and disseminate accounting and auditing best practices that are relevant to Islamic financial institutions, and to prepare, promulgate and interpret sharia-compliant accounting and auditing standards, as well as review and amend these standards as necessary. The BIBF has also been influential in the field, offering degrees and certification in Islamic finance, and conducting trainings in more than 15 countries. According to the Bahrain Economic Development Board (EDB), more than 30 countries have sought guidance from Bahrain when establishing their own Islamic regulatory frameworks.

Application Challenge

Conventional banks have been implementing International Financial Reporting Standard 9 (IFRS 9) since 2016, with full compliance mandated by the CBB beginning in 2020 (see Banking chapter). Islamic banks have found it more difficult to adjust to the new standard than their conventional counterparts, as IFRS 9 changes how Islamic banks establish and record allowances for possible future credit losses. This in turn affects the amount they must set aside for credit loss provision.

To comply with the regulations, banks will need to take a proactive approach in building up such provisions. Ratings agency Standard & Poor’s said that GCC Islamic banks may need to set aside additional provisions equivalent to 27% of their net operating income, depending on the health of their balance sheets. This is because under most Islamic financial standards developed prior to IFRS 9, banks were only required to recognise incurred losses.

IFRS 9 requires that banks be forward-looking and address possible future losses, but sharia principles forbid charging customers for potential future losses or events that may impact investments, financial holdings or loans. This imbalance makes it unclear how popular Islamic debt structures such as risk-sharing, borrowing-plus-profit arrangements, murabaha and musharaka will be impacted, since these structures are usually based on partnership contracts. With what qualifies as debt in Islamic finance being considered trading activities under IFRS 9, the international standard is not entirely applicable to the Islamic segment.

Local Standards

In a bid to move Islamic finance closer in line with IFRS 9, in November 2017 the AAOIFI released the Financial Accounting Standard 30 (FAS 30), which covers impairment, credit losses and provisioning across a range of asset types. With a primary mandate to standardise impairment models, FAS 30 introduced the concept of expected credit losses in financing contracts, as well as other asset classes primarily exposed to credit risk. It created a provisioning and impairment model for investments and other assets, including inventories, and superseded certain sections of the organisation’s previous FAS 25 standard regarding investment in sukuk. It also replaced rules on provisions and reserves under FAS 11.

Similarly to IFRS 9, FAS 30 introduced a forward-looking impairment model for credit losses that will support timely recognition of expected losses based on increasing credit risk. It also accelerated the recognition of different types of losses, again in line with IFRS 9. Under the local standard, assets and exposure are categorised based on the nature of risk involved, and three approaches are identified to deal with assessing losses: a credit-loss approach; an impairment approach; and a net-realisable-value approach. With IFRS 9 entering into effect in January 2020, harmonising loss-measurement guidelines across the Islamic sector and the conventional sector is likely to continue, perhaps significantly changing how Islamic financial institutions do business.

While conventional banks have been moving to incorporate IFRS 9 since 2016, FAS 30 has already affected local Islamic banks. For instance, Ithmaar Bank noted in its 2018 annual report that total owners’ equity fell to BD85.4m ($226.5m) at the end of that year from BD154.6m ($410.1m) in December 2017, largely because of the impact of FAS 30.

Performance

Islamic banking has been one of the fastest-growing segments of financial services in Bahrain since 1990, when it generated $7m in income. By 2008 the figure had grown more than five-fold to $37m. The years since have seen continued expansion, with the EDB reporting that Islamic finance recorded a compound annual growth rate (CAGR) of 17% between 2009 and 2013. This increase was supported by demand from businesses and investors in Asia and the Middle East looking to tap into a highgrowth market, and Muslim and non-Muslim investors looking for ethical alternative financing options.

According to the CBB, the aggregate balance sheet of Islamic banks in Bahrain rose from $27.1bn in the second quarter of 2018 to $27.6bn in the third quarter, ending the year at $27.9bn. Asset growth continued on an upwards trajectory in 2019, expanding by 7.6% to $30.1bn in the first quarter of the year and a further 2.3% to $30.7bn in the second quarter. The latter figure was equivalent to 81.2% of GDP, a notable increase from 71.5% in the second quarter of 2018.

Buffers, Liquidity & Profitability

Despite expansion of Islamic finance as a whole, subdued economic growth, oil price volatility, and rising domestic and regional competition made 2018 a challenging year for Islamic banks. This came even as non-performing facilities (NPFs) decreased for both retail and wholesale Islamic banks. Both segments’ earnings remained relatively stable, although retail banks recorded a drop in liquid assets and an increase in their loan-to-deposit ratio. Wholesale banks saw both liquid assets and their loan-to-deposit ratio drop.

At the same time, basic financial soundness indicators dipped, with the CBB’s March 2019 “Financial Stability Report” showing that Islamic retail and wholesale banks’ capital adequacy ratios (CARs) dropped between June and December 2018. According to the report, CAR among Islamic retail banks fell from 18.1% to 17.6% over the period, while Tier-1 capital levels dropped from 15.1% to 14.6%. In the wholesale segment the CBB found that cumulative CAR fell to 18.1% in December 2018, down from 20.2% in June of that year, and Tier-1 capital decreased by two percentage points, from 19% to 17%. The ratio of NPFs to capital provisions held steady at 1%. The central bank attributed the declining capital positions for both segments to “an isolated case from one bank” and noted that the fundamentals of the other institutions were strong.

Liquidity also slid during this period. The total volume of liquid assets available to Islamic retail banks dropped from 14.5% in June 2018 to 14.1% in December 2018, even as the segment’s loan-to-deposit ratio rose from 92.1% to 94.8%. Liquid wholesale assets fell from 13.4% to 12.6% of total assets, while the loan-to-deposit ratio dropped from 80.4% to 75.2%.

Profitability indicators were largely stable in both the retail and wholesale segments, with figures from the CBB showing that return on assets (ROA) for Islamic retail banks remained flat at 0.6% between December 2017 and December 2018, even as return on equity (ROE) rose from 78.2% to 78.5%. In wholesale, ROA increased from 0.9% to 1% in 2018, while ROE rose from 6.2% to 6.8%.

Lending & Provisioning

The CBB reported that the loan portfolios of Islamic retail banks became increasingly diversified in 2018, with personal and consumer finance’s share of total lending falling from 17.7% in June to 17.2% in December. The share of financial loans, the second-largest category, fell from 15% to 14.7%, while the share of manufacturing loans fell from 11.8% to 10.3%. Combined real estate and construction lending eased from 28.7% of the total to 28%. Meanwhile, wholesale banks’ lending to the manufacturing sector comprised roughly 20% of the total in both June and December, and financial lending jumped from 14.3% to 23.8%.

The rate of NPFs, for its part, improved in the retail segment, falling from 10.4% of total facilities in June to 9.5% in December 2018; in wholesale NPFs eased from 1.8% to 1.3%. Net provisioning in the retail segment rose from 32.5% to 34.8%, but fell in the wholesale segment, from 85.3% to 79.6%.

The most popular Islamic financing product in the retail segment at the end of 2018 was murabaha, at 60.2%, although this share was down from 62.9% in June. Ijara, or Islamic leasing agreements, followed, rising from 22% to 24% over the June-December period. Murabaha also represented the top lending instrument in the wholesale segment, at 66.8% at end-2018.

Consolidation 

Sharia-compliant listed companies – particularly banks – did not fare especially well in 2018. The BHB reported that the Bahrain Islamic Index closed the year at 823.1 points, down 24.4% from 1089.28 at the end of 2017. This was largely attributed to the poor performance of three listed Islamic banks.

The underwhelming figures at certain Islamic institutions have led some stakeholders to project an upcoming spate of M&As. In October 2018 the conventional National Bank of Bahrain (NBB), which is the second-largest bank in the country by market capitalisation, reported it was considering acquiring additional shares in BISB – the eighth-largest lender in the country by capitalisation – through a voluntary offer. NBB intends to acquire between 40.94% and 70.94% of BISB’s issued and paid-up capital, which would increase NBB’s stake to at least 70%. By July 2019 NBB had began the due diligence process for consolidation, and in September of that year BISB created a committee to evaluate NBB’s offer.

The NBB-BISB tie-up is in line with a broader regional trend, as Abu Dhabi, Saudi Arabia, Oman and Kuwait are all experiencing high-profile financial institution mergers (see Banking chapter). It is also not the only such deal in Bahrain. In September 2019 Kuwait Finance House announced an all-share offer to buy Bahrain’s Ahli United Bank for $8.8bn. Once finalised, the combined enterprise will be the region’s sixth-largest lender, with $100bn in assets. Looking to the future, additional mergers are likely as Islamic financial institutions seek to build scale and remain competitive by investing more in digital infrastructure.

Takaful

The takaful segment in Bahrain is mature and well developed by regional standards, with the Islamic insurance accounting for 29.1% of total gross written premium in the country in 2018, up from 22% in 2016. Bahrain had the second-highest takaful penetration in the GCC as of 2015, at 0.6%, after Saudi Arabia’s 1.5%, according to a December 2017 report by Alpen Capital. Major takaful and retakaful companies operating in Bahrain include ACR Retakaful, Hannover Retakaful, Medgulf Takaful, Chartis Takaful, Enaya, Takaful International and Solidarity Bahrain.

CAGR in the takaful segment was 6.6% between 2011 and 2016, outpacing conventional insurers’ CAGR of 5.3%. The value of the Islamic insurance market in Bahrain reached BD60.4m ($160.2m) at the end of that period. The central bank reported that in the year to March 2018 takaful assets rose by 20.5% to approximately BD191.6m ($508.2m).

As is the case with banking, elevated growth and rising competition within the broader industry are expected to push insurers towards consolidation. There has already been movement in this direction: in April 2017 Bahrain Kuwait Insurance Company increased its equity stake in Takaful International to a majority holding of 67.8% and converted its purchase into a subsidiary. In December 2017 sharia-compliant Solidarity Bahrain was created through a merger between Solidarity General Takaful and conventional Al Ahlia Insurance Company. Additional tie-ups could allow conventional insurers to attain growth and diversify existing business lines (see Insurance chapter).

Sukuk

Bahrain’s sukuk offerings are largely concentrated in Treasury bills and public debt issuance. Alarm over a potential sovereign sukuk default was raised in the months leading up to November 2018, when a $750m sukuk was set to mature. Fears were driven by the fact that the kingdom’s international reserves were estimated to be at $2.1bn in mid-2018 and public debt at 89% of GDP in late May of that year. However, in October 2018 Kuwait, Saudi Arabia and the UAE pledged $10bn in financing to help their GCC neighbour bolster its finances. As part of the agreement, Bahrain said it would eliminate its debt by 2022 and restructure its finances to save $2.1bn per year (see Economy chapter).

There are two main types of sukuk issued by the government: the Al Salam Islamic security, which has a maturity of 91 days, and Islamic leasing securities. According to the CBB, new issuances of Al Salam Islamic securities rose from BD72m ($191m) in 2009 to BD516m ($1.4bn) in 2018, a more than seven-fold increase. Mirroring the same trend, the total annual value of new Islamic leasing securities nearly doubled from BD507m ($1.3bn) in 2009 to BD976m ($2.6bn) in 2018. The balance of Al Salam Islamic securities measured BD129m ($342.2m) as of the second quarter of 2019, unchanged compared to the same period of 2018. The balance of Islamic leasing securities moderated to BD2.1bn ($5.6bn) at the end of June 2019, down from BD2.3bn ($6.1bn) a year prior.

Figures from the CBB show that the average return on short-term Treasury bills has been broadly positive. Average returns for Islamic Al Salam securities rose from 3.5% during the second quarter of 2018 to 4% in the third quarter and 4.2% in the fourth quarter, although returns moderated to average 4.1% and 3.3% during the first and second quarters of 2019, respectively. The average return on short-term Islamic leasing securities rose from 3.7% in the second quarter of 2018 to 4.2% and 4.4% in the third and fourth quarters of the year, respectively. However, this figure moderated to 4.3% during the first quarter of 2019 and to 3.7% in the second quarter. At the same time, average returns on local and international long-term Islamic leasing securities were relatively flat over the period, rising from 2.7% during the second quarter of 2018 to 2.9% one year later.

Reflective of the expansionary trend, demand for sovereign sukuk has been strong. In August 2019 the CBB reported that its BD70m ($185.7m), 91-day Treasury issuance was 165% oversubscribed, with total outstanding Treasury bills valued at BD2.1bn ($5.6bn) as of early that month (see Capital Markets chapter).

Corporate Potential

Corporate sukuk could also be set for a period of growth, although non-sovereign and quasi-sovereign offerings remain limited to one bourse-listed corporate issuance. However, ongoing regulatory reforms following the high-profile corporate default of UAE-based energy producer Dana Gas are expected to support future growth.

The reforms were sparked by an October 2017 announcement that Dana Gas would not redeem $700m in sukuk set to mature that month. The company claimed changes in the interpretation of Islamic finance meant the securities were no longer sharia-compliant and therefore unlawful in the UAE. Sukuk holders were unable to declare a debt default after UK and UAE courts issued injunctions preventing them from enforcing claims until the issue was resolved in court. In March 2019 the company reached a buy-back agreement with investors and said it would purchase $133m of its outstanding sukuk, reducing the total amount outstanding to $397m. “Dana Gas created a case for better regulations for corporate sukuk issuance,” Sabeen Saleem, CEO of the IIRA, told OBG. “We have seen new concepts and standards be introduced into the market as a result.” For example, the IIFM is developing new standards for sukuk issuance under an ijara structure, which could be used for construction and infrastructure financing.

Istisna’a, a contract to deliver a good or project in which payments are made when work is complete, and hybrid ijara-istisna’a contracts are the most common in construction, according to the IIFM. “In the case of ijara sukuk, assets are required for both asset-backed and asset-based offerings,” Ijlal Ahmed Alvi, CEO of the IIFM, told OBG. “The title remains with the issuing company in asset-based sukuk, while the title is transferred in asset-backed offerings. A majority of sukuk are issued on an ownership transfer basis. This is largely due to issues surrounding the cost of title transfer and the absence of a supportive legal system.”

Outlook

Islamic banking, securities and insurance continue to hold significant growth potential in Bahrain, supported by rising demand for ethical alternatives, a relatively untapped takaful market and ongoing reforms that could prompt a rise in corporate sukuk issuance. The government’s efforts to promote and expand financial technology could bring additional benefits to Islamic financial services (see analysis). From a sharia-compliant, blockchain-supported cryptocurrency exchange to open banking initiatives, Islamic offerings will continue to benefit from policies aimed at maintaining Bahrain’s competitiveness.