A SUPPLEMENT TO EUROMONEY/MARCH 1998: BAHRAIN
There is renewed conviction in Bahrain that it can hold on to its position as the Gulf’s main financial centre, after a long period in which offshore banks based in the emirate were questioning their raison d’être. Domestic institutions were constrained by its relatively small economy and some foreign banks were tempted to move their regional headquarters to neighbouring Dubai. Now, the emirate’s strictly regulated market once again appears attractive at a time of international political and financial instability.
Even so, the coming months will be challenging for Bahrain’s bankers. On the positive side, the emirate’s economy is in better shape than it has been for some years. Bahrain has low inflation, economic growth of 3.5% and a structural budget deficit that is increasingly under control. This year economic growth is expected to rise to 4% as work continues on government power and desalination projects.
“The economy did much better in 1997 as can be seen from the increase in corporate, consumer, government and construction business,” says Murad Ali Murad, general manager and chief executive of the Bank of Bahrain and Kuwait. “The government is putting more money into the economy.”
The financial-services sector has performed strongly. Local banks have reported steady growth: Bank of Bahrain and Kuwait has produced an 8% rise in profits and net income at the National Bank of Bahrain has increased by 11%. Some offshore banks have performed even better: Bahrain Middle East Bank, for example, has reported a 97% rise in profits to $18.7 million. The building of new head offices, including the elegant curved structure being constructed for National Bank of Bahrain in Government Road, is an indication that the banks expect the good times to continue.
The offshore banks are also benefiting from the continued strong performance of markets in other Gulf states, especially Saudi Arabia. The banks are reporting growing demand for project and corporate finance as governments in the region shift more responsibility for economic development onto the private sector.
But there are storm clouds which threaten this sunny picture. Bankers are waiting anxiously to see if the tension between the United States and Iraq turns into a full conflict. There are also worries about the fall-out from the financial crisis in Asia. Closer to home there is still some nervousness – though significantly less than two years ago – about the periodic outbreaks of civil unrest in Bahrain. These problems stem from resentment of the majority Shia population towards the minority Sunnis who retain real power and wealth in the emirate.
In the financial markets, there are question marks over the long-term prospects for Arab banks, which are undercapitalized by modern standards yet have resisted requests from regulatory authorities throughout the Gulf to merge. The local banks have to find a role in global markets dominated by much better capitalized institutions and to provide services to satisfy increasingly sophisticated investors and borrowers. Moreover, moves are afoot to make the Gulf market more competitive by allowing banks to have branches in other Gulf Cooperation Council (GCC) states (the GCC consists of Bahrain, UAE, Saudi Arabia, Qatar, Oman and Kuwait).
Bahrain’s continued success as an offshore centre will depend on the ability of the Bahrain Monetary Agency (BMA) to maintain the respect of the banking community by keeping up with – and in some cases exceeding – international best practice. Its credibility may also depend on its continued readiness to encourage new types of banking activity. So far the authority has enjoyed a strong reputation and is credited with creating an environment in which capital markets, Islamic banking and mutual funds can prosper under strong regulation.
According to a report by Moody’s Investors Service, effective regulation is key to Bahrain’s success: “To the extent that Bahrain’s position as a financial centre improves, it will be due in large part to the systemic development of regional capital markets – new banks and financial companies are created when economies and their capital markets are expanding. However, Bahrain has made sure that it is best placed to benefit from such developments by maintaining and enhancing its regulatory environment.”
One Gulf banker agrees. “You do not have tough regulations just for their own sake,” he says. “You have them because they will attract business. Countries in the rest of the region have bigger economies but they do not get the benefits of banking business because they are not as well regulated.”
Abdulla Saif is one of the world’s longest serving central bankers. Since his appointment in 1981, he has guided the BMA through a series of crises. Perhaps most damaging of these was the regional economic slump of the late 1980s which led to massive losses for some offshore banks and Bahrain’s domestic political unrest of the mid-1990s.
Albert Kittaneh, chief executive of Bahrain Middle East Bank, argues that the region’s banks have learnt important lessons from these crises. “These problems taught these banks to diversify,” he says. “When we entered the 1990s, financial institutions in the GCC were more prepared for adversity and investors learned to handle decline and boom. Although it was a relatively new market, investors were more educated in managing risks.”
Saif’s determination to preserve Bahrain’s reputation was reflected in his decision to increase the minimum risk-asset ratio for locally incorporated banks from 8% to 12% from the start of the year. This came on top of other measures last year which included the formalization of the concept of reporting accounts and the introduction of five accounting and auditing standards for Islamic banks. Banks have also been instructed to adopt the principles and recommendations of the Financial Action Taskforce on Money Laundering. “We will continue to ensure that Bahrain continues to follow best international practice in the area of regulation and supervision and deal quickly and effectively with any weaknesses that may come to light,” says the governor.
There are no longer as many offshore banks with offices in Bahrain as there were in the 1980s. There are now 45 with assets totalling $67 billion at the end of November. “In the last year assets have remained at between $60 billion and $70 billion and they are likely to stay in that range,” says one banker. “There will always be the occasional bank that wants to move out of the region altogether or move its offices to Dubai.”
Bahrain Middle East Bank exemplifies the way offshore banks have abandoned their traditional role of recycling petrodollars through global syndicated lending. This was a strategy that caused many to amass large losses in the late 1980s through their exposure to markets of which they had little detailed knowledge. “Our present strategy of focusing on investment banking and introducing innovative products for distribution in GCC countries has reaped far higher rewards than we anticipated when the strategy was adopted in 1993,” says Bahrain Middle East Bank’s chairman Abdul Rahman Salem al-Ateeqi.
Investment banking is sure to expand further as the offshore banks seek to find new roles in an increasingly competitive market. Implementation of the recent agreement by GCC finance ministers to allow firms to open operations in other GCC states may take some time because while some states, including Bahrain, are ready to see competition, other states are less enthusiastic.
But some banks are already moving to establish a regional presence. Gulf International Bank, an offshore bank in Bahrain, has been authorized by Gulf finance ministers to open branches onshore in the region. There seems little doubt that its management is preparing to move rapidly to open or acquire operations in the other GCC states. “In the longer term the quality of regulatory authorities in other parts of the Gulf will improve,” predicts one bank analyst. “This will remove one of the key reasons for operating in an offshore banking centre. Gulf International Bank seems to have concluded that its future is in being based onshore, offering the full range of banking services.”
Regional and international offshore banks are having to adapt to the changes in the market. In recent years, interbank operations have accounted for 70% of offshore banks’ assets and liabilities. The future, says Saif, will be a “diversification towards greater participation in the provision of finance associated with regional infrastructure requirements in power, water, transport and communications”.
Some institutions still use the tax advantages of Bahrain for booking loans while others use it as a convenient vehicle through which to conduct regional business in Saudi Arabia or the UAE. But many banks are keen to act on a broader regional scale. “When I first came here, I thought in terms of the GCC countries,” recalls one banker. “Now we are all looking much more widely to Lebanon, Jordan and, most significantly in the long term, to Egypt.”
Other offshore banks, such as Gulf International Bank and Chase Manhattan, are primarily focused on meeting the growing demand for capital in the Gulf. Governments are following the global trend of handing more responsibility for industrial development to the private sector. Family businesses, which are increasingly less reliant on government contracts, are looking for new sources of funds. Ironically much of the money lent by commercially-oriented offshore banks has been raised outside the Gulf.
As well as being the Gulf’s foremost capital market, Bahrain also sees itself as the base for the region’s growing Islamic banking sector, which Saif describes as the “last frontier for significant financial innovation. We are also giving Islamic banking and finance a special focus by exploring ways in which Islamic activities can be deepened and expanded, how both conventional and Islamic institutions might benefit from closer links, and how the concept of tradable Islamic financial instruments can be developed”.
Naser Nassief, chairman of Faysal Islamic Bank of Bahrain expects Islamic banking to grow by between 1% and 20% a year and believes competition will get even tougher as the leading banks, including Citibank, Arab Banking Corporation and Gulf International Bank, open Islamic subsidiaries or divisions. “I have no doubt that in the future one in four leading banks will be Islamic institutions,” he says.
The problem for local banks is that even the largest are small by global standards. Even if they bowed to pressure from the BMA to merge into larger institutions, they would still not be large enough to compete on a wider stage. One banker points out that it would be necessary to combine at least the top 16 Arab banks to create one institution in the world’s top 10. “But it seems inevitable that as the GCC becomes more of a single market there will be more cross-border institutions and the number of Arab banks will fall significantly,” says one Bahraini banker. “I could envisage the day – but not for some time – when there are only four serious Arab banks.”
A more pressing challenge for the banks is to cope with the immediate political and economic difficulties facing the Gulf. Bahrain is better positioned to withstand any financial consequences of any new Gulf war than it was when Iraq invaded Kuwait in 1990. Then interbank depositors cut their credit lines. Today the prospects for Gulf economies and offshore banks are much brighter. International banks are also aware that the names of those banks which cut credit lines and withdrew staff in 1990 have not been forgotten. “We have been paying for our decision heavily in terms of lost contracts and customers,” says one Japanese banker. “We will think much more carefully before taking such steps again.”
The impact of the south-east Asian crisis is harder to predict. The reduction in economic activity in Asia will reduce demand for oil and petrochemicals and could bring lower oil prices. The impact on GCC budgets will be less dramatic as most have made conservative assumptions on oil price, basing their calculations on a price of $15 a barrel (compared to just over $16 at the beginning of the year). Offshore and onshore banks have also been hit by their exposure to south-east Asia though they are reluctant to quantify the scale of the problem. There will be reduced business for banks in countries such as Qatar which have partly financed their natural gas development on the basis of guaranteed purchases by companies in South Korea and Japan.
While the overall effects of the Asian crisis will probably be negative, some bankers believe there will also be some benefits. “There will be cheaper imports because of the devaluation in the Far East,” says Abdullah el-Kuwaiz, general manager of Gulf International Bank. “Those states will also delay big petrochemical projects which make it easier to sell the products from this part of the world and, with the reluctance to invest in Asia, there will be new sources of funding for this part of the world.”
A test of the impact of the crisis will be the ability of Bahrain’s companies to go on exporting to east Asia. Early evidence is encouraging with sales of the aluminium industry’s production company Aluminium Bahrain holding steady. “We are still delivering all our product lines to the Far East,” says Hussein Al Ali, sales manager of the industry’s sales and marketing company.
Getting the markets moving
Broader and deeper capital markets are needed to match Arab capital with the region’s capital needs. Bahrain wants to be at the centre of those markets. The challenge facing Bahrain as it seeks to maintain its position as the Gulf’s financial centre, is to create markets which ensure that more Arab funds are directed at regional projects.
Abdulla Saif, governor of the Bahrain Monetary Agency (BMA), has no illusions about the scale of the task. “We have an Arab world that has substantial capital requirements but which also has a significant proportion of its own capital – as much as $800 billion by some recent estimates – invested outside the Middle East region,” he says. “If we, who have the closest knowledge of the risk-reward opportunities, do not ourselves invest significantly in the Arab world, then we cannot expect less familiar foreign investors to support us.”
The key, according to Saif, is to “broaden and deepen our capital markets”. The government will be making its first public issues of development bonds in April. These will be listed on the Bahrain stock exchange.
Companies also need to be pursuaded to float on the stock market. “We have to try to encourage family businesses to look at capital markets for their future development,” says sheikh Ahmed bin Mohammed Al Khalifa, director of the Bahrain Stock Exchange. “There is more awareness of the need to do this. World Bank data suggests that 85% of family-run companies tend to disappear in the third generation as families get larger. We will soon be nearing that point in this region.”
Gulf stock markets, headed by Bahrain, Oman and Kuwait, have performed extremely well in the past year, largely on the back of a booming bank sector, and avoided the worst of the fall-out from last year’s Asian stock-market crashes.
The Bahrain stock market has also had some success in attracting money from local investors. There has been a rapid expansion in the number of collective investment schemes or mutual funds which have risen to 361 since they were authorized in 1992 and are being marketed by 40 financial institutions. Some bankers have expressed concern about the number and quality of schemes approved. But Saif is adamant that the market is properly regulated. “These schemes will grow as the requirement of the market grows,” he says. “Those who come up with new products will meet with success. This is an indication of how sophisticated the investor is. Our job is to ensure that the investor is well informed and there is proper transparency.” This is endorsed by Albert Kittaneh, chief executive of Bahrain Middle East Bank. “When we established a fund, it took a lot of time to get BMA approval,” he recalls. “The regulations for these investment schemes are extremely rigorous.”
One of the highlights of equity issuance last year was the $250 million offering for the Arab Insurance Group in Bahrain, Muscat, Kuwait and Cairo, which was five times oversubscribed. Another success was the issue for Bahrain Duty Free which was 23 times oversubscribed. “This shows the success that can be achieved,” says one observer. “But the fact that so much money was chasing these issues also reveals the lack of opportunities.”
The reality is that markets such as Bahrain, where last year the value of shares traded totalled only Bd180 million ($450 million), are too small to satisfy large investors. The ministry of finance and the BMA have tried to give new impetus to the Bahrain Stock Exchange. New management has been appointed with the brief to modernize a market that at present has listings from 38 companies, five mutual funds, four currency warrants and two bonds. Market capitalization stands at Bd2.85 billion.
New measures include opening up the stock exchange to non-resident foreigners, the introduction of electronic trading and the establishment of a clearing and settlement house. Links, including cross-listing of shares, have been established with the markets in Muscat, Cairo, Amman and Kuwait.
At present there are two fundamental obstacles to the development of a deeper equity market in the region. One is lack of access to equities from Saudi Arabia, where many of the Gulf’s biggest companies are based. Although they have allowed the creation of two funds for investment in local shares, the Saudi authorities are still very reluctant to lose control of the market for shares in Saudi companies.
Second, there is not enough market research. “We need to have more information. That is why we are talking with Bloomberg about putting information on the Internet,” says Kittaneh. “This will allow foreign emerging-market investors to make an investment decision about Bahrain. Once this has happened the markets will start to move.”
