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Middle EastApril 6 2009

Tighter times for Bahrain

The global economic downturn is catching up with Bahrain's banks. However, the country still has some cause for optimism, particularly in its Islamic banking sector. Writer Michael Imeson
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Rasheed Al-Maraj, Central Bank of Bahrain governor

Bahrain has been hit hard by the global credit crunch and economic downturn. Although it is the most diversified and least indebted country of the Gulf Co-operation Council (GCC), and has been a major financial centre in the region for more than 40 years, it became the first to have its sovereign credit rating outlook downgraded from "stable" to "negative" by Moody's at the beginning of the year.

The reason given for the re-rating was the country's reliance on finance and hydrocarbons. Oil and gas production accounts for just under 20% of gross domestic product (GDP) and finance for more than 25%. Bahrain has more than 400 licensed financial institutions, most of which are wholesale operations generating revenues from outside the country.

The Bahraini government announced in February it would issue $800m in bonds to finance house building and support the economy. "Anecdotal evidence suggests that housing market activity has started to soften," says the latest economic research report from Gulf Finance House, the Bahraini Islamic investment bank. "We are concerned about the growth prospects of Bahrain, given the steep decline in crude oil prices," add the authors.

Bahrain's real GDP growth is expected to decelerate to 3% this year, compared with 6% in 2008 and 8% in 2007, according to Kuwaiti investment company Global Investment House. Although this forecast compares favourably with those for Saudi Arabia (1.4%), the United Arab Emirates (2%) and Kuwait (2.5%), it is smaller than Oman's (3.5%) and Qatar's (9.4%).

The steep fall in crude oil prices from their peak last summer, output contraction across other key economic sectors, tight liquidity conditions and the fall in asset prices will make 2009 a challenging year for the GCC, says Dr Ala'a Al-Yousuf, Gulf Finance House's chief economist. "As we anticipated in our previous report, the GCC has now firmly joined the last group of countries to be impacted by the global financial crisis," he says. On the plus side, the situation is creating attractive opportunities for cash-rich investors looking for gains over the medium to long term.

Most GCC banks will see profit contractions as a result of slower growth in business volumes, believes Mr Al-Yousuf. Some banks will need to recapitalise or merge and, in the process, cut back on credit expansion to improve capital adequacy metrics.

Al Bakara buoyant

One of the region's most senior bankers is based in Bahrain. Adnan Ahmed Yousif is president and chief executive of Al Baraka Banking Group, the 28th largest bank by Tier 1 capital in The Banker's latest Top 100 Arab Banks listings, and the fifth biggest out of the 12 Bahraini banks in the Top 100. Al Baraka is also 14th in The Banker's most recent Top 500 Islamic Institutions measured by sharia-compliant assets, which makes it the leading Islamic bank in Bahrain.

Mr Yousif is also a board member of the Bahrain Stock Exchange, chairman of the UK's European Islamic Investment Bank, and chairman of the Union of Arab Banks, the Lebanese-based association which has more than 300 Arab banking and other financial institutions as its members.

He is keen to stress that the region is not in recession. "We are in a manageable slowdown," he says. "In this part of the world, in the Gulf, we are an exporter of capital. Governments have an excess of cash. For 2009 and 2010, all government deficits will be covered by their reserves."

Al Baraka released its 2008 results in February, which showed a net profit of $201m, up 37% on 2007. Assets grew by 8%, deposits and investment accounts by 10%, and financing and investments by 10%. "There was good expansion in operating income, balance sheet and deposits," says Mr Yousif. "We even had growth in the fourth quarter. We have not been caught up in the financial crisis because of our sharia principles; we are not allowed to buy debt and are not involved in derivatives. We do not borrow from international markets, but from local markets. We are a retail bank and rich in cash. We don't grow our balance sheet quickly, we grow it gradually. We are a net lender, not a net borrower."

He claims to have anticipated the subprime crisis before it happened in the summer of 2007 and correctly forecast how it would spread. "We alerted all our units in January 2008 not to grow so fast and maintain a lot of liquidity. That strategy has yielded benefits for the group. But you can't isolate yourself totally from international events. If there is a recession in the countries where we operate, we will have some difficulties."

Mr Yousif lists some of his bank's achievements in 2008: income and balance sheet expansion; implementation of Basel II (its capital adequacy ratio is a very high 23.5%); opening about 45 branches in Turkey, Jordan, Egypt, Pakistan and Algeria; increasing the capital of some of its subsidiary banks; and gaining approval for a new subsidiary in Syria.

"We also improved our IT. We implemented new systems in five subsidiaries – in Bahrain, South Africa, Pakistan, Egypt and Lebanon. We asked two units, in Sudan and Algeria, to put in new core banking systems."

Expansion will continue in 2009. "We will open about another 50 branches in Algeria, Tunisia, Egypt, Jordan, Turkey and Pakistan," says Mr Yousif. "We will have the initial public offering (IPO) of our Syrian subsidiary and localise our Pakistan operation. We are changing our corporate identity and will build a new office in Bahrain Bay."

Ahli optimistic

Ahli United Bank (AUB) – 27th in The Banker's Top 100 Arab Banks, and fourth biggest in Bahrain – made a profit of $255.7m in 2008, down 13.7% on 2007. This was on an operating income of $665.5m, up 4.5% on 2007. However, in the last quarter it incurred a loss of $24.4m, drastically down on the $70.4m profit it made in the fourth quarter of 2007. This demonstrates the sudden change of fortunes experienced by most banks in the second half of 2008, especially in the final quarter.

The results were weaker because of higher levels of specific and precautionary provisions taken in light of the worsening situation. They included net loan loss provisions of $97m, four times higher than the 2007 figure, to ensure adequate coverage of problematic exposures and to maintain asset quality.

A year of two halves

Nevertheless, Adel El-Labban, AUB's chief executive, is pleased with the results, and the fact that the bank was voted Bank of the Year for Bahrain in The Banker's 2008 awards for the third year in a row. "I think the best way to describe 2008 is a year of two halves," says Mr El-Labban. By this he means that the first half witnessed the continuation of the economic boom in the region, of which AUB was a beneficiary both in Bahrain and the other countries where it operates. In the second half, the economy was badly affected by the Lehman Brothers collapse in September, which damaged confidence everywhere, including the Gulf."

Despite the deteriorating conditions, AUB was able to secure extended refinancing for two years of $800m out of its existing medium-term syndicated loan facility from October 2009 to October 2010 at competitive terms. The bank provides a wide range of wealth management, retail, corporate, treasury and private banking services. It owns significant stakes in banks in Kuwait, Qatar, Oman, Iraq and Egypt and has a wholly owned subsidiary in Britain.

"In a year marked by an unprecedented global credit crisis and an increasingly challenging business environment, AUB has been able to report a profit of $255.7m after proactively identifying and absorbing the cost of fully providing [or] writing off problematic risk exposures," says Fahad Al-Rajaan, AUB's chairman.

"While 2009 remains a very challenging year ahead, we nevertheless see opportunities on a number of fronts," he added. One of these will be its entry into the life insurance market across the region, both conventional and Islamic (takaful), in joint ventures with the UK's Legal & General. AUB also plans to convert Bank of Kuwait and the Middle East, in which it has a 75% stake, into a fully fledged Islamic bank. AUB has only $23.2m of sharia-compliant assets and therefore ranks 26th among Bahrain's 49 Islamic banks in The Banker's Top 500 Islamic Institutions. The conversion will increase its profile in this area.

AUB has been an acquirer of stakes in other banks in recent years and there is no reason to assume it will stop because of the current climate. In fact, one of the silver linings of the crisis is that it has depressed share prices and asset values of banks massively across the region to the extent that some will soon make attractive targets, provided acquirers carry out the necessary due diligence to uncover any risks that may be lurking beneath.

Arcapita downgrading

Those who believe that Islamic banks are having a relatively easy time should look at the problems afflicting Arcapita Bank, the Bahraini investment bank which also has offices in Atlanta, London and Singapore. In January, Standard & Poor's downgraded its long and short-term credit ratings on Arcapita from BBB/A-2 to BB+/B. It also placed the long-term rating on CreditWatch with "negative" implications. The reasons given were the bank's "weak liquidity profile" and predictions that its investments, especially in private equity and property, would fall in value.

The bank's chief executive, Atif Abdulmalik, says he is "disappointed" at S&P's review. He says the uncertainty surrounding the private equity sector globally was a dominant factor in the downgrade. Arcapita, which changed its name from First Islamic Investment Bank in 2005, is 38th in The Banker's Top 500 Islamic Financial Institutions and third in Bahrain, based on its $3.8bn of sharia-compliant assets as of June 2007 (which rose to $5.1bn at the end of 2008). The bank is 67% owned by more than 270 individuals and institutions, mainly from the Arab Gulf region, and 33% is held by its management.

"In recent months, we have been successful in attracting $300m in two-year deposits from a group of strategic investors, and we are in the process of securing a significant equity increase from certain sovereign wealth funds," says Mr Abdulmalik. "These commitments have been made by investors with a close understanding of the Arcapita business model, and their investments demonstrate a high degree of confidence in the opportunities and growth that Arcapita continues to offer over the medium to long term. Our leverage ratio is modest, at approximately 2.2, and our capital adequacy is at 17.5%, almost 50% more than the minimum required by the Central Bank of Bahrain."

Mr Abdulmalik points out that every investment business is suffering from the limited availability of bank finance and reduced liquidity among investors. "However, even against this challenging market, we managed to record a net income of $42.7m for the six months ending on December 31, 2008," he says.

What measures is he taking to cope with the downturn and how is he planning for the eventual upturn? "Throughout the portfolio, we began implementing actions to protect earnings more than 18 months ago, and although revenues are down almost everywhere, earnings have held up satisfactorily in comparison," says Mr Abdulmalik. "We have successfully focused on strengthening the balance sheet with a range of measures, and our intention is to ensure that we can move quickly and decisively when the environment improves."

Enter the regulators

Bahrain's banking system remains sound, thanks in large part to the strength of the regulatory and supervisory regime. "Central Bank of Bahrain rules and regulations and our directions to banks have constrained excessive risk-taking and we have, for example, ensured that banks are not over-exposed to any particular economic sector," said Rasheed Al-Maraj, the bank's governor, in a speech in February. "Our rules and regulations were not always popular when we introduced them, but we knew that controlling banks' risk-taking would be in the long-run interests of the kingdom."

When Lehman Brothers collapsed, there was a rapid acceleration in the outflow of capital from Bahrain and other parts of the Gulf, as international banks discovered they needed their liquidity closer to home. "Recognising the liquidity pressures on Bahrain's banking system, the central bank took action to alleviate the problem," explained Mr Al-Maraj. "We extended the range of collateral that we would accept in our lending operations with the banking system, so that this now includes long and short-term ijara sukuk issued by the Kingdom of Bahrain. We are also looking at extending the scope of acceptable collateral still further.

"Our main policy initiative, however, was to establish a foreign exchange swap facility. This allows banks that have US dollars to bring them to the central bank to swap for Bahraini dinar at no cost. As the Federal Reserve and other leading central banks had taken measures to provide US dollars to financial markets in almost unlimited quantities, banks in Bahrain could obtain dollars and swap them for dinar whenever needed. The result has been to offset to a large degree the liquidity impact of capital outflows. We have done so in a way that is consistent with maintaining our currency's peg to the US dollar, which is key to maintaining confidence in the economy more broadly."

Real economy

As liquidity has dried up and international bank lending has been sharply reduced, this has affected the financial system's ability to provide credit to the real economy, the producers of goods and services. "Although the Bahraini economy will continue to grow, the rate of growth will slow down, in line with the rest of the GCC," said Mr Al-Maraj. "It seems reasonable to assume that the impact will be similar to those of previous economic slowdowns. In particular, we anticipate declines in bank profitability as business opportunity shrinks. The supply of credit is also likely to remain constrained at least until advanced country banking systems are able to resume their role as suppliers of credit to the rest of the world."

Whatever the current problems, there are still plenty of people and institutions in Bahrain with big ideas. Sheikh Saleh Abdullah Kamel, chairman of the General Council of Islamic Banks and Financial Institutions, based in Bahrain, announced three months ago that the world's largest sharia bank would be launched this June, with paid-up capital of $11bn. The Islamic Development Bank would be its largest shareholder and Organisation of Islamic Conference countries would also be investors, but the bulk of the capital would be raised from an IPO on the Bahrain Stock Exchange.

Whether this turns into a live project or remains a pipe dream, we shall have to wait and see. Either way, no one can say Bahrain is lacking in confidence.

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