Steady wins the race: New strategies are being considered for conventional and Islamic banks

Even after half a decade of challenges – first from the global financial crisis and later from regional and internal instability – few doubts remain about the resilience of Bahrain’s banking sector. The country’s traditional role as a financial hub means the industry is robust and varied. There are banks that perform basic banking functions, such as lending retail deposits against the spread, others that offer sophisticated investment vehicles for ultra-high-net-worth individuals and everything in between. Outlooks differ by industry segment, but what they have in common is that they operate in a regulatory environment that is widely considered to be both prudent and modern, offering access to significant capital from the Arabian Peninsula.

Specific areas of focus and lines of business have been profoundly changed by the global financial crisis, however, and that has triggered an evolutionary phase in parts of the sector. For lenders in the retail segment, it has been business as usual into 2013, which has meant a continued effort to meet the needs of local clients and capture new business as the economy grows.

Meanwhile, in the wholesale sector, banks licensed for an offshore role – which has partially worked in the past – are no longer as effective. As in New York, London, Frankfurt and other global centres for financial services, these players are experimenting with new models, tweaking old ones and searching for different opportunities to fit new realities.

GROWTH DRIVERS: The long-term outlook anticipates the oil economy of the region and the combination of Bahrain’s own growth prospects and workforce will ensure a positive future for its banking industry. Specific growth drivers in the short term, however, may depend on factors beyond Bahrain’s borders. At the top of that list is the global economy and the demand it generates for investment vehicles, commercial financing and other advanced financial services on offer from the kingdom’s banks. Positive regional growth will also be a boost for Bahraini banks, in particular in Saudi Arabia, which is just 25 km away and across the King Fahd Causeway. Bahrain’s financial sector has historically played an important role in Saudi Arabia and Saudis are frequent visitors to the island country, representing an important part of the tourism economy. An IMF projection for the GCC region expects GDP growth at 3.7% in 2013, down from 5.6% in 2012. Economic performance over the past few years may have been distorted to some degree, however, by regional instability; political protests in 2011 led some consumers to hold off on large purchases and that pent-up demand may explain some of the results from 2012.

With economic growth likely to be crimped by global and regional conditions, leaders in GCC countries are planning some counter-cyclical spending to help local economies, which should create lending opportunities in the medium term for Bahraini banks. The plan is for a regional infrastructure drive, focused on Bahrain and Oman, the two GCC members with the most limited hydrocarbons resources. The other GCC members each have agreed to contribute $2.5bn to both countries for infrastructure projects, leaving each with $10bn to spend. Commercial and large retail banks will have the opportunity to lead or join loan syndicates, but lenders of all types and sizes stand to benefit by financing subcontractors or underwriting mortgages, for example.

Outside Bahrain, financing opportunities will come from Saudi Arabia, where population growth is driving demand for more infrastructure across all sectors, and from Qatar, where spending in preparation for the 2022 World Cup is set to drive new business. The event could also benefit Bahrain by seeing the realisation of a long-held plan to build a causeway between it and Qatar, adding more connectivity and tangential economic opportunities. In Saudi Arabia, plans call for a record budget of some $218.6bn for 2013. Of that total, $17.3bn is allocated for infrastructure projects.

SIZE & SCOPE: Bahrain had 76 licensed conventional banks in operation as of March 2013 and these were classified as either retail (23) or wholesale (53). The same categories apply to sharia-compliant versions of banks in Bahrain, with six and 20 Islamic licences, respectively, as of January 2013.

Growth in licences over the past decade has been strong; roughly a third to a quarter of the conventional banks are less than 10 years old, as are almost half of Islamic banks. Because of Bahrain’s status as a financial centre for the rest of the region, the greater number of licensees reflects the state of the economy of the Arabian Peninsula; increased oil revenue has led to a larger number of both personal and institutional investors that are seeking investment options.

Bahrain’s conventional retail banks follow a universal banking model save for three specialists: the Bahrain Development Bank, Eskan Bank and Oasis Capital Bank. Eskan Bank was established in 1979 to provide housing finance to low- and middle-income Bahrainis, and while that has remained a focus, the lender has also moved on to general retail banking, Islamic finance, treasury services, and property development and management, according to its website. Oasis Capital Bank’s licence restricts it to private banking, according to the Central Bank of Bahrain’s (CBB) Register. Its parent entity is Mumtalakat, the kingdom’s investment arm that is focused on all sectors apart from oil and gas.

Three lenders dominate activity in the retail sector: the National Bank of Bahrain (also within the Mumtalakat portfolio), BBK (formerly the Bank of Bahrain and Kuwait) and Ahli United Bank. Also serving retail customers, but from a different licence category, are two microfinance lenders: Ebdaa Bank and Family Bank, which are both sharia-compliant.

WHOLESALE BANKS: Prior to a sector reorganisation in 2006, wholesale licences were called “offshore” institutions. These banks operate outside of the local economy, typically as outward-focused entities servicing the region or beyond, and cannot operate branch networks in the kingdom. They are not prevented from investing in Bahrain or serving local clients, but can only access customers with accounts of BD7m ($18.4m) or more.

Within the wholesale category most licensees can generally be grouped into two categories: commercial and investment. The former entails basic business lines, such as corporate lending and trade finance. The latter tends to be characterised by models such as private equity, real estate and other investment services. Securities underwriting plays a smaller role than it would for an investment bank elsewhere, in large part because raising capital in the Arabian Peninsula is rarely a problem, and therefore there are few incentives to develop a prospectus, thus attracting minority shareholders and accepting their influence and rights, or to commit to a regime of periodic public disclosures.

LICENCE CATEGORIES: Within the wider financial services landscape, there were 405 licensees grouped into six main categories: conventional banks, Islamic banks, insurance companies, investment firms, specialised licensees and capital markets licensees. The six groups correspond to different regulation volumes in the CBB Rulebook. Banking is covered in Volume One. For both conventional and Islamic wholesale banks, different licences can often work for similar enterprises, as overlap exists between investment firms, banks and other vehicles, and choosing a specific category of licence to apply for means considering factors such as how an entity will raise funds or whether to be subject to the Basel Committee on Banking Supervision’s guidelines.

For retail banks, exposure to the global financial crisis was indirect and has not lingered. Retail banks are focused on servicing their clients, whose needs have not profoundly changed as a result of the crisis. At the end of 2012 the aggregated balance sheet of retail licensees was worth $70.95bn – up 11.7% from $63.5bn at the end of 2008. This total was roughly 38.1% of the banking system – excluding the CBB – as a whole, which was valued at $186.3bn.

Meanwhile, retailers’ share of the banking sector overall is growing. At the end of 2008, according to the CBB, the overall banking system reported a balance sheet of $252.4bn and the retail segment’s share was 25.2%. Retail’s steady growth is less of a factor than the wholesale banking sector’s decline in size. That segment’s aggregated balance sheet was $188.9bn in 2008 but had shrunk to $114.6bn by the end of 2012.

Loan growth in 2011 was 12.3% for the retail banks, according to the CBB 2011 annual report, which is the most recent available. Outstanding credit of all types reached BD6.4bn ($16.8bn), up from BD5.7bn ($15bn) at the end of 2010. Full-year figures for 2012 were not yet available as of March 2013, but what is known thus far is that lending increased by 7.5% in the first 11 months of the year, according to an update from Bahrain’s Economic Development Board. Demand for the year was expected to be especially high for consumers, in line with expectations that regional and local political instability in 2011 may have led some to delay large purchases, such as cars and houses. That pent-up demand could mean that when full-year statistics are published, they might show that consumers played a larger share in the year’s growth. Commercial lending accounted for 63% of total lending in 2011, with consumers comprising 33.5% and the government constituting 3.5%, according to CBB data.

REGULATION: The CBB, formerly known as the Bahrain Monetary Agency, has been the single regulator over all financial matters in the country since 2002, when it took over responsibility for insurance and capital markets regulation. The legal framework in Bahrain is described in the Central Bank of Bahrain and Financial Institutions Law 2006. In early 2013, bank regulators were focused on the new Basel III banking standards, corporate governance, and monitoring fees, charges and interest rates on behalf of retail consumers.

Regulators say their banks will be ready to operate according to Basel III standards whenever those become the global norm. Changes from Basel II primarily affect capital, liquidity and leverage. Timetables for the implementation of these various changes begin in 2014 with the gradual phasing in of the new capital requirements and they extend to 2019. Opposition from the banking industry worldwide may delay parts or all of that process, however, and the CBB is monitoring those developments. The regulator is unlikely to force Bahraini banks to adopt Basel III unless other developed world banks do as well, because doing so could leave them less competitive in the international market. Ongoing haggling over the standards in January 2013 between bankers and regulators in Switzerland resulted in an agreed-upon delay to fully meet the liquidity coverage ratio (LCR), which requires banks to hold enough easy-to-sell assets to be able to withstand a 30-day credit squeeze in the event of a crisis. Implementation was initially set for 2015, but will instead take place over a longer period of time. The Group of Governors and Heads of Supervision, a collection of banking regulators overseeing the Basel Committee on Banking Supervision, announced that the negotiated settlement would require banks to meet 60% of LCR obligations by 2015, with the rest phased in over the ensuing four years.

Although some of these negotiations are perhaps merely the result of the ever-present tension between banks and regulators, the LCR issue is an instance in which the global banking environment has changed since the Basel III rules were announced in 2010. Those new rules were established before Europe’s sovereign-debt crisis, and lenders have argued that the amount of highly liquid assets that the banks would be required to own under the new LCR requirements would perhaps force them to buy more sovereign bonds than they would want to, which could tie their financial health too closely to the financial health of governments.

GOOD GOVERNANCE: In Bahrain, regulators are also looking to boost corporate governance in 2013 by adding transparency and accountability in the field of executive compensation. They sought consultation from licensees in late 2012 on a plan to incorporate elements of the Bank for International Settlement’s disclosure requirements for remuneration and elements of the Principles and Standards for Sound Compensation Practices of the Financial Stability Board, another Basel-based entity through which banking regulators meet and push for standards in regulation. That consultation period is now over and the CBB is expected to introduce regulations in 2013. They could include mandating disclosure of all compensation for boards and senior management, rules for claw back payments for executives who do not perform and guidelines being set to ensure that incentives for executives are aligned with the long-term interests of shareholders, instead of potentially short-term, unsustainable goals.

“The CBB has been ahead of its peers in the region on a number of fronts, be it in terms of its regulatory approach or its strong relationships with the banks through its comparatively unique consultative methodology,’’ Hassan Jarrar, the CEO of Standard Chartered Bank’s operations in Bahrain, told OBG.

NEW MEASURES: Some of these measures would be unprecedented elsewhere in the GCC region, where there is a shorter history of awareness of and compliance with corporate governance principles in areas such as securitisation, heeding the rights of minority shareholders and transparency. Within Manama’s banking community, there is opposition to these proposed changes, and the CBB has been advised by bankers to implement them in stages rather than at once. No matter how the CBB decides to apply them, these reforms exemplify Bahrain’s approach to being a financial centre in the region – it believes that strong regulations will attract more capital over time and it has empowered its regulator to pursue the goal.

Attracting more capital and growing the financial sector are both important parts of the country’s overall economic strategy, which is focused on diversification. Bahrain’s oil reserves were smaller to start with than all of its neighbours in the Gulf. The country’s leadership has always known that it would be the first to face a post-oil future, and diversification efforts have focused on industry, tourism and finance. The financial services sector is now the largest single employer in Bahrain, and provides an important source of economic opportunity for locals both in advanced managerial jobs and other positions; over 80% of the sector’s workforce is Bahraini, according to the CBB. It also accounts for 27% of GDP, according to the regulator, making it the largest non-oil contributor to the economy.

Bahrain’s status as a financial centre has, to an extent, been challenged in recent years, as neighbouring states have borrowed from the kingdom’s strategy for economic diversification. Offshore financial centres have been created in Dubai and Qatar as well. The advantages to operating in Manama that Bahrain hopes financial services professionals will perceive include higher quality regulation and a more-developed legal environment; access to skilled and experienced workers, both white-collar and otherwise; a more cosmopolitan lifestyle; and historic ties to the Saudi economy.

Another possible outcome could be multiple financial centres in the region, which would repeat a pattern seen elsewhere, in which financial centres exist in proximity and evolve different or complementary offerings. There appears to be plenty of room for specialisation, much like how New York is the epicentre of finance in the US and yet, Hartford, Connecticut, which is 160 km away, acts as the centre for the insurance industry. While Bahrain’s offerings in the financial sector are varied and comprehensive, the nation has also emerged as a source for specialisation in some advanced fields. Islamic finance is an example; Manama and Kuala Lumpur are the cities with the most expertise in the world and almost every non-financial support organisation for the practice – accountancy bodies, ratings agencies, standard-setters and others – are to be found in one of the two locations. Bahrain is also emerging as a spot from which reinsurers like to service the GCC and the wider region, as well as for complex investment funds and other pooled-investment vehicles.

CENTRE OF THE ACTION: Bahrain’s rise to prominence came in the 1970s, when civil war in Lebanon led to the migration of banking talent from Beirut. Manama was built up thanks in part to its connection to Saudi Arabia. However, in the future, this is expected to be less of a factor in making Bahrain a financial centre, as the past decade has seen development in Saudi Arabia’s own financial sector. Manama has also increased its worldwide focus as a response to globalisation and the further development of its own financial services community. Thus, banks focused on investment are adjusting their business models to reflect changes since the global financial crisis. That means lowering exposure to real estate, where the region has been left with ample supply, and also changing the way partners and clients are invited to share in an investment.

UPFRONT: Before the financial crisis, investment banks were turning profits for their shareholders using what is locally referred to as an upfront mark-up model. The banks would find a profitable investment and invite clients in, but would inflate the value of the target investment first. The difference between the original value of an investment and the price at which stakes were sold to investors brought some initial profit to the bank, along with some transaction fees. In the case of private equity investments, in which the bank took an active role in the management of an investment, management fees were also applied.

For the banks, the benefits of the upfront mark-up model meant getting cash at the start to help with managing liquidity without banks needing to use their own capital to make an investment. The model did, however, oblige them to ensure returns large enough to make investments attractive to their clients even with the increased price at the start.

Until the financial crisis imposed a more conservative investment logic on investors worldwide, the model seemed to meet the needs of all parties. Bahraini wholesale banks used it to invest in a range of sectors, including real estate, shipping, and sale-and-leaseback transactions. Geographic distribution was focused on the region, although it also extended elsewhere.

Bahraini banks now find themselves in a position similar to banks worldwide, in that investors are more cautious with investment opportunities and are often unwilling to allow a bank the luxury of booking some profits at the start. “When you start substantially increasing your mark-up, it puts pressure on you to get a great sale price at the end,’’ said Silvan Varghese, the COO and deputy general manager of Khaleeji Commercial Bank, a sharia-compliant retail lender. “Investors are now gradually coming back to the market – they are tired of sitting on the sidelines. But many are looking for more stable cash flows, and investment income rather than capital appreciation. They are ready for steadier options.”

TIME TO EVOLVE: This does not necessarily mean a departure from the real estate sector, where so many banks suffered exposure in the financial crisis, Varghese said. It could simply mean a shift in focus from new construction to existing buildings. Instead of financing greenfield projects, funds are now more likely to be pooled and invested in established assets, with perhaps more of an investor’s return coming from a yield that is built on monthly rent payments, rather than on a large sum collected from new sales – similar to how a common real estate investment trust would operate.

It could also mean a return to the more aggressive investment model that is based on capital appreciation, without the upfront mark-up model. Banks are increasingly expected to cut investors in at cost, and need to take a stake in the target using their own capital. Whereas the risk before was in ensuring that an investment had enough upside to make it work for all parties, it is now also a question of how much a bank should spend of its own money on any single investment. Central bank regulations say a bank cannot invest more than 15% of its own equity on any single asset. The CBB is also pushing its investment banks to keep transaction fees reasonable. “The corporate credit initiative originally faced resistance, yet institutions finally realised the benefits of a well-integrated corporate credit system. Banks are now better able to understand the risks associated with any loan,” said Abdulwahid Janahi, CEO of The Benefit Company, which handles ATM and point-of-sale transactions in the kingdom.

For retail banks, being able to take deposits is considered a significant advantage and wholesale banks may also seek to buy retail banks or licences in response to the changing environment. Current and savings accounts (CASA) serve as low-cost sources of capital, allowing banks to find profit margins by deploying their capital in activities that promise smaller returns, and are therefore inherently less risky.

The downside of a CASA-based strategy is that it may not last; if more banks chase the same pool of consumers, competition could drive account interest rates higher in an attempt to attract customers. Offering higher interest rates could lead to smaller profit margins and diminishing returns from CASA. However, this strategy is likely to pay off for more banks for a longer period if there is an extended run of broad-based economic growth, bringing new customers to the banks and increasing current account sizes.

CONSOLIDATION: Size may be a solution for the banking sector in the coming years, with many in the sector seeking opportunities to grow. Consolidation has typically been perceived as difficult in Bahrain, in part because many banks do not have diversified ownership structures, but are instead held by an individual or a family. The idea that selling out to a competitor could be perceived as a sign of weakness has been a disincentive in the past. However, as the sector evolves, so too are attitudes. Some bankers are realising that the fastest way to grow their capital base is to merge. As time goes by, some banks’ shareholding structures are becoming so fragmented that no one person or family would be identified as the seller.

Both conventional and Islamic banks were increasingly talking about joining forces, particularly for sharia-compliant services. This is an area where converting from an investment-based wholesale model to a commercial one is especially challenging because the mainstays of commercial finance, such as lending to corporate consumers, financing exports and imports, and guaranteeing entrepreneurial activities, are often slightly more expensive for consumers who opt for sharia-compliant methods over conventional ones. Although Islamic banks are able to find clients who are willing to pay a bit more, this segment of the market is not large enough to depend on. “You have to be competitive with conventional banks,” said Varghese. “There is only a small segment of customers who will pay a premium.”

OUTLOOK: As of early 2013, a handful of mergers had taken place and seve ral pairings were in discussion. Financial institutions are also pursuing new models, geographic and sector expansion, preserving the best of old models and participating in the coming infrastructure drive. It is expected that a combination of these moves should help ensure steady profits for the future.