Bahrain as model of Islamic banking and finance

Manzar Naqvi

Bahrain’s Islamic finance (IF) industry has been in existence for more than 30 years, and the industry gained momentum in the last 5-10 years. Bahrain operates a dual system where Islamic financial institutions (IFIs) operate in parallel with conventional banks. The first Islamic bank was established in 1979 and several Islamic banks (IBs) have been licensed over the following decades. The IB industry registered rapid growth in assets and market share. The other segments of the IF industry, including the Takaful industry and the Islamic asset management, also date back several years-the latter began as a way for IBs to make use of their excess funds. The last 10 years have seen Bahrain increasingly play a premier role in the overall development of the IF industry. Bahrain, with 22 Islamic banks, has the largest concentration of IB operations among the countries that operate dual banking systems. The country also pioneered the issuance of Sukuk in 2001, was the first country to launch a dedicated Islamic index and has been in the forefront in the development of the Takaful industry. In addition, Bahrain hosts a number of organizations that are central to the development of IF. These include: the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI); the International Islamic Financial Market (IIFM), and the Islamic International Rating Agency (IIRA).
The IB segment dominates the IF industry in Bahrain. At end June 2015, the IB industry accounted for 94 percent of IF industry assets. The Sukuk segment follows a distant second with 5 percent. The seven Islamic insurance companies (Takaful) and two Re-Takaful companies that operate in the Kingdom account for less than 1 percent. Other Financial Institutions (OFIs), which comprise mostly investment funds with close to a 100 Islamic funds, account for a miniscule 0.6 percent (Figure 1).
The IB sector has registered rapid asset growth, but it remains a small player in the global IB industry. Total assets of IBs (excluding the windows) grew strongly from USD 1.9 billion in 2000 to USD 24.7 billion in 2008 representing a Compound Annual Growth Rate (CAGR) of 44 percent. Thereafter, Islamic bank assets have grown slowly, equivalent to a CAGR of 0.4 percent between December 2008 and November 2015. The market share of IBs (wholesale and retail banks) increased to 13.2 percent of the banking industry assets and their assets amounted to about 83 percent of Bahrain’s 2015 GDP. In the retail segment, the share of IBs is higher and amounts to 21.6 percent of total assets. Despite this rapid growth, Bahrain accounts for less than 2 percent of the global IB assets.
Bahrain’s IF industry is complex and diverse. The IB industry consists of two broad segments-6 retail IBs that focus on the domestic and regional markets for business and 19 wholesale IBs with a broader geographical footprint. There is cross-shareholding between wholesale IBs and retail IBs, conventional wholesale banks and Islamic wholesale subsidiaries, and between Islamic retail banks and conventional retail banks. Most IBs are privately-owned with participation from foreign private shareholders from the Gulf Cooperation Council (GCC), primarily of Saudi, Omani, Kuwaiti and UAE origin, but one retail bank is indirectly majority owned by the Bahraini government via a state-owned conventional retail bank and social security institutions. The industry also includes large and systemically important IB groups as well as numerous small scale banks that focus on niche markets.
On the asset side, investments represent a large proportion and financing consists primarily of debt-based instruments that transfer rather than share risks . At end June 2015, domestic assets accounted for 58 percent of the total assets of IBs, and the foreign assets included investments in the GCC, other Arab countries, Europe and the Americas. Financing items account for about 40 percent of total assets and most of the financing items are debt-based. Muraba?ah and Ijarah respectively account for over 70 percent and 19 percent of total facilities by retail IBs whereas financing facilities of wholesale banks are concentrated in Muraba?ah, which alone accounts for 90 percent of the total facilities. Risk sharing products such as Musharakah and Mu?arabah are, on the other hand, very small. A significant share of the financing is utilized in real estate (construction, commercial real estate and retail mortgages) which, respectively, accounts 28 percent and 22 percent of retail and wholesale IB financing. Other sectors accounting for a significant share of the financing are manufacturing, trade and consumer finance. The off-balance sheet component, which is equivalent to 7 percent of assets, mainly consists of assets funded with restricted investment accounts (RIA) while letters of credit (LCs) and bank acceptances account for about 2 percent of assets. Overall, while the aggregate balance sheet structure of the IBs is relatively diversified, many of the smaller IBs are reported to have concentrated portfolios.
Bahrain IBs finance their operations using both domestic and foreign sources of funding. Domestic sources of funding account for about 64 percent, of which private non-bank enterprises and households account for about 36 percent. Interbank deposits are a significant source of funding, accounting for 18 percent of total funding sources. Government deposits are small, accounting for about 4 percent. Other funding comes from head offices and bank affiliates as well as Sukuk issuance. Equity capital and other capital-like liabilities account for about 30 percent. Foreign funding comes mostly from the GCC and other Arab countries. Overall, while the bulk of the assets are funded by the banks’ “own funds” and current accounts.
The financial fundamentals of IBs have been strengthening. The industry has for some years now been consolidating. At end September 2015, aggregate Capital Adequacy Ratios (CAR) were 20 percent for wholesale IBs and about 15 percent for retail IBs compared with a statutory minimum of 12.5 percent. Non-performing financing (NPFs) is, on the other hand, elevated particularly for retail IBs. The IB sector remains profitable on aggregate, but wholesale IBs have registered a compression in profit margins to reach negative territory in September 2015. Liquidity positions are tighter compared to conventional banks, with retail IBs registering lower levels relative to the wholesale IB sector.
The operating environment is, however, becoming challenging due to headwinds from lower oil prices. With the slump in oil prices persisting, domestic and regional Gross Domestic Product (GDP) growth is projected to slow down and system wide liquidity has tightened, thus IBs, like their conventional counterparts, could face asset quality and liquidity pressures. The concentration of assets in cyclically sensitive sectors (construction, real estate, trade and manufacturing) increase risks for the IB sector.
Bahrain has enacted legislation that is explicit on permissible IB practices, products and institutions. The Central Bank and Financial Institutions Law, Legislative Decree 64, confers on the Central Bank of Bahrain (CBB) regulatory and supervisory powers for all financial institutions, including Islamic ones. The regulatory and supervisory responsibility was transferred to the CBB, from the Bahrain Monetary Authority (BMA), in September 2006. The CBB Law is supplemented by CBB rule books, which includes separate independent self-standing regulatory frameworks for conventional and IBs. The framework allows for the provision of IB products and services through various modes, including stand-alone banks, unit/business lines, branches, and subsidiaries. The CBB has been adapting its prudential framework to cater for risks that are specific to IB. Standalone IBs are issued with IB licenses and licensing requirements for conventional banks with Islamic windows have been customized. The regulatory capital adequacy requirements for IBs are based on the IFSB-15 prudential standard, apply an alpha factor of 0.3 and do not consider PER and IRR as part of the eligible capital. Segregation regulations designed to limit the risk of commingling conventional and Islamic funds are in place.
On the other hand, the regulations governing loan classification and provisioning, large and related exposure limits, anti-money 3 IBs are required to maintain the funds raised by way of Islamic deposits (demand deposits, URIAs, etc.) separately from other funds under the control of the bank. The self-financed pool (which includes funds in current accounts) is maintained separately from the URIA pool. However, funds from both pools may be comingled to finance the same asset. Islamic windows must maintain separate books for Shari’ah compliant banking activities to ensure no comingling of conventional and Islamic funds.
laundering and combating the financing of terrorism (AML/CFT), and investments in real estate, and securities apply equally to conventional and IBs. The CBB has also taken several steps to strengthen Shari’ah compliance by IBs and to reduce reputational risk. A Centralized Shari’ah Board was recently established and its mandate includes: overseeing product development IFIs and Islamic windows, strengthening Shari’ah compliance, providing guidance to the CBB in issuing rules and regulations for the sector, providing guidance to the courts in legal cases involving IFIs and acting as the Shari’ah Board for the CBB. Bahrain has adopted the AAOIFI standards for Shari’ah compliance and requires IFIs to establish a Shari’ah Supervisory Board (SSB), and conduct a Shari’ah review or Shari’ah audit. External auditors are also required to ensure Shari’ah compliance as part of ensuring internal controls.
The consumer protection framework incorporates the key elements, including a legal basis, disclosure requirements, consumer education and cost-effective dispute resolution processes. The Central Bank of Bahrain and Financial Institutions Law 2006 (‘CBB Law’) confers on the CBB duties to protect the legitimate interests of customers of financial institutions. The rulebook for IBs covers, among others, disclosure and reporting requirements. More specifically: All IBs are required to publish audited annual and reviewed quarterly financial statements. The financial statements have to be prepared in accordance with the Financial Accounting Standards (FAS) issued by AAOIFI. When there are no specific accounting standards under AAOIFI, IBs must use International Financial Reporting Standards (IFRS). Banks must disclose the main features of all capital and equity related instruments and URIAs. The SSB of IBs are required to publish a statement regarding the bank’s state of Shari’ah compliance. IBs are permitted to use mechanisms (such as the PER) to smooth the low profits on URIAs accounts in low return periods, but bank customers have to be informed of their use. IBs are also required to appoint independent board of directors representing (explicitly or implicitly) the interests of IAHs, and to ensure that independent directors represent all stakeholders. In addition, banks are urged to have one of their SSB members to be in the Corporate Governance Committee of the Bank, representing RIAs and URIAs holders. Bahrain has in place an Alternative Dispute Resolution (ADR) forum that customers may go to for the resolution of disputes involving IBs. The reporting framework and supervisory process take account of the specifics of Islamic modes of banking. The regulatory framework mandates that AAOIFI standards must be used by IBs for financial reporting purposes. There is a dedicated unit for supervision of IBs and specific off-site and on-site examination manuals. Bahrain has also made advancements in building capacity for assessing financial stability risks in IBs. The CBB established the Bahrain Institute of Banking and Finance (BIBF) to facilitate training and education in IF. IBs are supervised on a consolidated basis but cross-border supervision is currently not fully in place. There is, however, no difference between conventional banks and IBs regarding the corrective and enforcement actions and the processes formulated in the regulatory framework.
The CBB has been at the forefront of developing financial markets and instruments to facilitate liquidity management by IBs. This includes developing Sukuk markets as well as the launch of Shari’ah-compliant CBB liquidity management instruments. In 2001, the Bahrain government introduced the long-term Ijarah Sukuk and short-term AlSalam Sukuk to provide IBs with investment opportunities and to facilitate systemic liquidity management by the central bank. There is no overnight standing credit facility for IBs in Bahrain, but the Ijarah Sukuk securities can be used as collateral for banks to obtain funding from the CBB for tenors of 1-week. The Monetary Policy Committee of the CBB sets the applicable rates. In 2015, the CBB launched a new Shari’ah compliant Wakalah liquidity management instrument to absorb excess liquidity of the local retail IBs and place it with the central bank. The instrument has been developed based on a standard contract of the IIFM. The duration of the Wakalah is one week, which facilitates short term liquidity management. There is no special resolution framework for banks, nor does the framework distinguish between conventional banks and IBs. Banks are subject to the same insolvency framework as non-financial corporates. Nevertheless, in liquidation, the regulations give priority to demand deposits followed by RIAs, since the latter is an off-balance sheet item with restrictions in the manner as to where, how and for what purpose the funds are to be invested. Thereafter, the order of ranking is URIAs, and shareholders and creditors are last. Shari’ah boards do not play a role in resolution decisions and there are currently no cross border resolution arrangements. IBs are covered by the same deposit insurance regulatory framework as conventional banks, but there are separate schemes within the framework. Bahrain’s pre-funded deposit insurance structure is based on the Shari’ah compliant contract of Takaful whereby the deposit insurer is only an agent operating and managing the pool of funds that are collected as contributions from participating IBs. When one of the members fails, the reimbursements for insured deposits are paid from respective Takaful funds. The coverage limit is 20,000 Bahraini dinars (about USD 53,000) and the deposits covered include Islamic deposits and URIAs but not RIAs.