Despite increasing competition, Bahrain maintains position as regional leader for Islamic finance

Bahrain’s sharia-compliant financial institutions enter 2017 after weathering the tumultuous economic environment and changing regulatory landscape of the previous year. Despite the challenges, the kingdom’s Islamic banks continue to expand in the domestic market and beyond, while activity in the newly reinforced sharia-compliant insurance sector is well positioned to continue along a trajectory of premium growth, outstripping that of its conventional counterparts.

IFS REGIONAL CENTRE: Bahrain is widely recognised as the GCC’s principal centre for Islamic financial services (IFS), and it is home to many of the global industry’s leading institutions and standard setters. This development has come about despite sharia-compliant financing’s relatively late start in comparison to the conventional sector.

Historically, there was great suspicion of interest-based banking in the region, most notably on the part of King Abdulaziz, Saudi Arabia’s founding ruler, and Sheikh Isa bin Ali Al Khalifa, who ruled Bahrain until 1932. However, in the absence of a modern Islamic banking model it was the conventional lenders who formed the basis of Bahrain’s early banking industry.

This began to change in 1979 when Bahrain Islamic Bank (BIsB) was established as the first Islamic financier in the kingdom. The sharia-compliant banks that followed it into the Bahraini market over the next decade formed a nucleus of IFS activity, establishing the kingdom as the region’s IFS trendsetter, a status that was cemented in 1990 when a number of regional Islamic financial institutions chose Manama, the capital city, as the home of a new standard-setting body, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

The sharia board of AOOFI, made up of scholars from across the GCC, Malaysia, Iran, Sudan, Pakistan and the US, has in subsequent years emerged as the global IFS industry’s most influential fiqh (Islamic jurisprudence) body, its standards having been fully adopted in Bahrain and Qatar, and it is looked to as an important reference for regulators across the world.

SETTING STANDARDS: Manama is also home to the increasingly influential Islamic International Rating Agency (IIRA), which performs a similar function to other major credit ratings agencies, such as Standard & Poor’s and Moody’s, but through the lens of sharia compliance. The IIRA has embarked on a period of proactive client acquisition since it underwent a management change in 2013, and by 2016 it had clients in 12 countries. Its focus to date has been on the GCC – Saudi Arabia is the most recent addition to the IIRA’s country list, after the agency received approval to operate there in 2016 – but it also targets promising markets further afield, such as Turkey. The basic fiduciary ratings it provides takes cognisance of important aspects of Islamic financial institutions’ operations, such as asset management, corporate governance and sharia governance. Banks and insurance companies make up the bulk of its ratings list, although the organisation is currently developing a ratings methodology for investment houses and has issued two sovereign ratings, for Bahrain and Turkey.

Several other institutions that provide support or standards for the domestic and international Islamic financial services sectors are based in Manama, including: the non-profit International Islamic Financial Market (IIFM), which provides standards for Islamic capital and money markets, the General Council for Islamic Banks and Financial Institutions and the Sharia Review Bureau. More recent arrivals to the scene include the for-profit organisations Thomson Reuters Global Islamic Finance Hub and Deloitte’s Islamic Finance Knowledge Centre, as well the Islamic centre at the Bahrain Institute of Banking and Finance, which offers a range of undergraduate and postgraduate courses centred on sharia-compliant finance.

BANKING SECTOR: Around 29% of Bahrain’s total banking sector assets are accounted for by its vibrant Islamic banking industry, according to global financial services company EY. A loyal retail and corporate base have helped the sector to maintain stable investment accounts and finance during the challenging period that began with the political unrest of 2011, helping the segment to outperform its conventional counterpart in terms of growth.

As of January 2017, 26 Islamic banks were licensed to operate in the kingdom, all but three of which – the Kuwait Turkish Participation Bank, Türkiye Finans Katılım Bankası and the sector’s most recent arrival BOK International of Sudan – were locally incorporated. Like conventional banks, sharia-compliant financiers are licensed to either operate as retail institutions or wholesale operators. The oldest of the seven retail players is BI sb, which was established in 1978. BI sb has since been joined in the market by Al Baraka Islamic Bank, Al Salaam Bank, Ithmaar Bank, Khaleeji Commercial Bank, Kuwait Finance House and IB Bank. The majority of the banks operate modestly sized networks of between seven and 10 branches, although by the close of 2016 Ithmaar Bank had established a total of 17 branches in the kingdom.

A DIVERSE OFFERING: As the work of interpreting sharia in the context of financial services has advanced, Bahrain’s Islamic retail banks have delivered to the domestic market an increasingly sophisticated array of products and services, including murabaha and istisna’a (types of Islamic sales contracts), mudaraba (profit sharing), ijara (leasing), musharaka, (joint ventures), al salam (short-term bonds) restricted and unrestricted investment accounts, syndications and other structures found in conventional finance.

The 19 Islamic banks operating under wholesale licences are granted access to the local market but primarily function as offshore investment entities, each maintaining only a single branch in Bahrain. The oldest of these institutions is ABC Islamic bank, which commenced operations in Manama in 1985. ABC shares the wholesale space with the sharia-compliant windows of global players, including Citi Islamic Investment Bank, as well as the wholesale divisions of large Islamic retailers and large investment firms with a presence in other financial capitals.

From a performance perspective, the crowded nature of the domestic market and the effects of low oil prices since late 2014 have combined to form a challenging environment. The Islamic retail segment showed a modest return on assets (ROA) of 0.4% in September 2015, according to the most recent “Financial Stability” report by the Central Bank of Bahrain (CBB), the same level as the previous year.

For Islamic wholesale banks, ROA decreased to -0.1% for the same period, indicating negative earnings. The asset-based funding model prescribed by sharia means that Islamic banks were particularly vulnerable to the real estate slump which afflicted most of the GCC in the wake of the global economic crisis of 2008.

During the intervening years Bahrain’s financial industry has succeeded in lowering its non-performing assets, although the challenges that arose in 2015 resulted in an uptick of non-performing loans to reach 11.7% and 4.7% for retail and wholesale financiers, respectively, in September 2015.

In general, the sector’s financial soundness indicators are robust, however, with the CBB recording an aggregate capital adequacy ratio of 15.6% for retail institutions and 19.5% for wholesale operations, well in excess of the regulatory minimum. “The entire region is going through a time of increased pressure on governments to cut back spending and increase revenues, all of which have an effect on banks eventually,” Hassan Jarrar, CEO of BIsB, told OBG. “Bahrain has been lucky to have the Gulf Development Programme to maintain spending for the medium term.”

TAKAFUL: The development of Islamic banking in Bahrain has acted as a catalyst for the wider IFS sector, including what has become a sizeable sharia-compliant insurance industry. As of October 2016 a total of six takaful (Islamic insurance) operators were licensed to provide Islamic insurance services in the kingdom, the first of which – Takaful International Company – was incorporated in 1989. Since then it has been joined in the market by Alhilal Takaful, Chartis Takaful Enaya, Medgulf Takaful, Solidarity General Takaful, T’azur Company. Like their banking counterparts, Bahrain’s sharia-compliant insurers have grown at a rapid pace in recent years, with the takaful market expanding almost 14 times in terms of premiums between 2003 and 2014. The gross contributions (the sharia-compliant equivalent of premiums) accounted for just over 20% of the insurance sector’s total premiums, according to the latest data from the CBB.

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 the Hannover Retakaful company, which has since been joined in the market by ACR Retakaful. Between them they took BD92.5m ($245.4m) in premiums in 2014 compared to the BD319.9m ($848.5m) accounted for by conventional reinsurers. Establishing the kingdom as a major regional centre of takaful and retakaful has been a priority for the CBB for some years, and one which it continues to pursue through the implementation of an advanced regulatory framework for the sector.

ISLAMIC INVESTMENT: Bahrain’s increasingly diverse IFS sector has garnered a reputation as a crucible for the formation of new investment instruments. This development has been greatly aided by government action. The kingdom is one of only a small number of nations, which includes Malaysia and Qatar, to include a sukuk (Islamic bonds) issuance programme as part of its public debt management strategy. The Bahrain Monetary Agency, the precursor to the CBB, issued the first sovereign sukuk based on an ijara (Islamic leasing bonds) structure in 2001, with the dual intention of providing a new source of funding for the government and boosting the kingdom’s status as an IFS centre by establishing a sharia-compliant liquid asset that could be held by Islamic financial institutions.

EFFECTIVE SUPPLIER: The country quickly became the most active issuer of sukuk in the region, offering 99 international instruments worth $7.9bn between 2001 and 2015, according to data from the IIFM, although the sukuk issued in the UAE during its real estate boom were greater in terms of value.

Sovereign issuances still play an important role in Bahrain, with as much as 25% of the government’s total financing needs fulfilled through Islamic offerings. These domestic currency and dollar instruments are governed by a well-defined schedule. The Bahraini-dinar-denominated Al Salam sukuk is issued on a monthly basis, and carries a three-year maturity; the short-term Ijara sukuk – another Bahraini-dinar instrument – is also a monthly offering and has a tenor of six months; and the dollar-denominated Ijara sukuk – a long-term offering – is issued on an ad-hoc basis and features tenors of between two and 10 years.

The government issuances play an important role in bridging Bahrain’s fiscal gap, and therefore the price of Bahraini sovereign sukuk is keenly observed by economic commentators. Deteriorating credit ratings and a mounting public debt burden have raised the cost of government borrowing in 2016 (see Economy chapter), while an increase in external debt issuances by other GCC countries facing a fiscal shortfall has limited demand for Bahraini debt. This scenario is likely to continue over the medium term.

ISLAMIC BOURSE: The CBB and the Bahrain Bourse (BHB) have recently leveraged the kingdom’s reliable pipeline of sharia-compliant debt offerings to broaden the range of activity on Manama’s exchange. In January 2015 the BHB launched a new mechanism, the first of its kind in the Middle East, which allows both individual retail investors and institutions – domestic and foreign – to directly subscribe to government issuances of sukuk and bonds through registered brokers, and thereafter trade them on the secondary market at the BHB. In order to encourage retail investors, the BHB specified a low minimum subscription rate of BD500 ($1326) for 500 bonds or sukuk, issued at a par value of BD1 ($2.65) each. The implementation of the system represents a significant broadening of exchange activity and provides a useful route to yields for the investment community.

The BHB has also taken steps to improve the visibility of sharia-compliant products on the exchange through the introduction of a new index in September 2015. The Bahrain Islamic Index is a standardised tool, which tracks BHB stocks compliant with the principles of sharia, and comes as part of the effort to help establish the kingdom as the leading regional centre for the provision of Islamic financial services. The 17 companies that make up the Bahrain Islamic Index include a number of Bahrain’s most recognisable brands, such as Alba, the 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 central pillar of this regulatory structure is the CBB Rulebook, which consists of six volumes and covers conventional banks, Islamic banks, insurance licences, investment company licences, specialised licences and capital markets.

As with conventional institutions, companies operating in the Islamic segment must also be cognisant of a number of national laws, including the Central Bank of Bahrain and Financial Institutions Law of 2006 and the Bahrain Anti-Money Laundering Law of 2001.

The task of supervising the activities of sharia-compliant institutions is given to the CBB’s Islamic Financial Institutions Supervision Directorate (IFISD). The IFISD follows similar procedures to the conventional sector, including the holding of formal meetings with Islamic banks at least twice each year in order to discuss prudential matters, as well as the carrying out of a financial review every 12 months, which involves the IFISD examining the institution’s financial report prior to its being put before that institution’s board.

While Bahrain has succeeded in maintaining its edge as a global leader in the provision of comprehensive IFS regulation, the growing popularity of the sector in regional and global markets means that rival regulatory systems are emerging to challenge the kingdom’s long-held position. The CBB, however, has one advantage to help it see off this challenge; namely, a legislative and regulatory structure that is capable of accommodating gradual reform.

The evolution of the regulatory framework is affected through updates to the rulebook and ad hoc notifications by the CBB, which benefits greatly in this process from the large number of standard-setting organisations established in Bahrain. For example, in seeking to tackle the issue of a lack of liquidity management tools for the Islamic segment, in 2015 the CBB used a standard created by the IIFM to establish a one-week Islamic deposit facility based on the wakalah (contract of agency) model. The new instrument 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. Being a CBB instrument, the deposit is classified as a level 1 asset, according to the Basel Committee definitions, and therefore brings the liquidity management capacity of Islamic banks closer to that enjoyed by conventional lenders.

FINE TUNING: The takaful segment has also been targeted for regulatory enhancement in recent years, most notably the 2014 introduction of a new Operational and Solvency Framework for the takaful and retakaful industry. The framework is the result of a long process of consultation between the regulator and market participants, and substantially revises the takaful rules in a way that the CBB believes will spur growth in the industry while protecting the interests of both the stakeholders and operators.

One of its key features 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 manage temporary fluctuations in policyholders’ contributions, it was deemed by the CBB that meeting any regulatory shortfall in policyholders’ funds with a loan from shareholders’ funds to be paid with future contributions raised the prospect of concealed solvency risks. The new framework also introduces a requirement for high-quality liquid assets, similar to the Basel III rules for banks.

Bahrain’s IFS regulatory framework continues to evolve, including at the institutional level. To date, Bahrain has utilised a decentralised model of sharia governance, by which IFS institutions operate their own sharia boards, which rule on the compliance of new products and services. However, as the IFS market matures and the instruments developed by its participants become ever more complex, the CBB has indicated its intention to create a centralised sharia board to ensure a consistent approach to the development of products and services in the industry. Having a centralised body would represent a key advance for the sector, helping Bahrain to maintain its position as a sharia governance leader.

OUTLOOK: Regulatory issues will continue to dominate the public discussion surrounding Bahrain’s IFS sector. The formation of the CBB’s central sharia board will be a key concern for industry participants, who will be keen to assess its impact on product approval times and rates. The standards of AAOIFI, which Bahrain subscribes to, will also continue to influence the sector. At the convening of AOOFI’s new sharia board in 2016; the organisation revealed that between September 2014 and February 2016 it had issued six drafts for new sharia standards, revised 13 standards and launched 11 new research studies. As of 2016 a total of 19 new standards were under development, some of which are expected to be implemented during 2017.

In terms of performance, Islamic banks and insurance companies face the same challenges as their conventional counterparts. The most notable hurdle to overcome is the negative sentiment engendered by subdued oil prices. However, a slowdown in business volumes is mitigated by a Gulf aid programme, which has enabled the government to maintain its capital spending programme (see Economy chapter).

Bahrain’s IFS institutions, like their conventional counterparts, are also well defended against adverse economic conditions thanks to a long history of prudent regulation. Therefore, the most significant performance question for 2017 is how effectively individual IFS institutions can maintain their profit margins in an increasingly competitive environment.