Basel III and International Banking Regulations in Bahrain

Introduction: Global Financial Crisis and Bahrain's Banking Sector

Following the global financial crisis of 2008–2009, there has been a worldwide debate about improving regulation in banking systems, which has impacted banks across the globe. The global crisis led many banks worldwide to report financial losses — primarily due to connections with subprime mortgages in the United States, or because they were affected by the acute liquidity and credit crunch that followed, or by the ensuing economic recessions in their own countries and regions. Since the crisis, however, there has been heightened public interest in Islamic banks, primarily those located in the Gulf countries, as they were believed to have been relatively less impacted by the crisis.

The very nature of how Islamic banks function — requiring all financial transactions to be trade-based and linked to some form of an asset — is cited as the primary reason they were not as severely affected. Some even argue that had the principles of Islamic finance been applied to conventional banks, the financial crisis would not have occurred. While the major concentration of Islamic banks remains in the Gulf region, they have since spread to all regions of the world and now operate in both Muslim and non-Muslim countries.

Bahrain is one of the countries that has traditionally played a very important role in the development of Islamic banking and finance. The country is also considered to possess the most developed Islamic finance infrastructure among the Gulf Cooperation Council (GCC) countries. However, worldwide regulatory changes and the development of certain events in recent years have placed the banks of Bahrain in a position of considerable discomfort. One of the major regulatory changes affecting Bahraini banks is the announcement and imposition of Basel III requirements introduced in the latter half of 2014. These regulations were imposed to ensure better management of banks and to create a strong framework to prevent an economic crisis like the one of 2008.

The primary requirements of Basel III include standards for a supervisory framework that measures and controls the large exposures of banks, set to come into effect from January 1, 2019. The regulations stipulate that large exposures — or those linked to a group of connected counterparties — should not exceed 25% of the bank's capital base. This poses a problem for Bahraini banks, as most of their investments and risk exposure are concentrated in the oil sector, often with a small number of very large players. An additional problem is the perceived use of banks in the region for terror financing; the U.S. has introduced several regulations that affect the ability of banks to exchange local currency for dollars. These factors have collectively placed Bahrain's banks in a difficult position in recent years.

Major International Regulatory Developments Impacting Bahrain's Banks

The banks of the GCC region appeared to have been less affected by the 2008 global economic crisis than their counterparts in advanced economies. According to the World Bank, the primary reasons for this were their limited exposure to the subprime assets that triggered the crisis, their focus on traditional lending and the mobilization of savings, and their lesser dependence on global financial markets. In recent years, however, these banks — especially those in Bahrain, considered among the soundest financial systems in the GCC — have faced problems arising from changes in the international regulatory framework for banks.

While addressing a seminar on changing banking regulations following the global financial crisis on June 19, 2014, the CEO of Standard Chartered Bank of Bahrain stated: "Ever since the 2008 global financial crisis, the banking industry worldwide has seen nothing short of an avalanche of new regulations. Such regulations, though mostly originated in the U.S. and Europe, have, and will continue to have, direct implications for the rest of the world, including Bahrain and the region at large. As a result, the banking industry has been undergoing a significant transformation the likes of which has not been seen since Dodd-Frank."

One of the regulatory changes that have impacted the banking sector globally, as well as the banks of Bahrain, is the enactment of new Basel III compliance regulations coming into effect from January 1, 2019. These new regulations aim to govern the environment in which international banks operate, create specific roles for banks in self-monitoring, and empower supervisors to enforce capital requirements and ensure banks hold capital above the minimum level at all times. The regulations also aim at early intervention to prevent crises, and require transparency through the implementation of a formal disclosure policy covering risky products and operations.

The challenge for Bahraini banks is to integrate their successful yet somewhat distinct banking and financial systems with the Basel III requirements, which include minimum capital requirements and additional rules for measuring credit risk, operational risk, and market risk. A major requirement of the new regulations is that a bank's own regulatory funds — not borrowed money — must cover its capital requirements. One of the most pressing problems for Bahraini banks in adhering to the new norms is the requirement to reduce risk exposure: Basel III requires all banks to maintain maximum exposure of 25% of their capital to any one industrial sector.

Bahrain has a very large oil economy, and the country as a whole is heavily dependent on oil revenues. Consequently, most of the risk exposure of Bahraini banks is concentrated in this sector. Furthermore, the players in the oil and petroleum sector tend to be large groups or companies, with only a limited number of major players comprising the market. Basel III regulations require that Bahraini banks do not over-expose their risks to any one company or group of companies — yet this is precisely the structure of Bahrain's banking relationships with the oil sector. It would therefore be difficult for Bahraini banks to comply with these two key requirements simultaneously.

Additionally, the new regulations stipulate that Bahraini banks must report to supervisors and make public any risk exposures equal to or exceeding 10% of their capital base. Given that a large portion of the risks undertaken by these banks exceeds that threshold, most of their exposures would be subject to scrutiny by supervisors and the broader banking community.

Current Regulatory Trends and Moody's Outlook Downgrade

As a result, many international banks have curtailed their correspondent banking services to regional and local banks. Some banks have also refrained from dealing with exchange houses. These consequences of the new U.S. regulations have affected a large segment of the banking sector and the population in Bahrain and abroad, particularly expatriates. The issue of Islamist militancy and flows of money to Iran has placed some Gulf banks under heightened scrutiny by U.S. regulators. The problem has assumed such significance that Bahraini authorities approached the U.S. Treasury to discuss it in February 2016. The governor of the Central Bank of Bahrain was present at those meetings to explore how to resolve international banks' reluctance to deal with Bahraini banks.

The pressure that Bahraini banks face from new international banking regulations was made evident by a note from the rating agency Moody's. On July 9, 2015, Moody's Investors Service changed its outlook for Bahrain's banking sector from stable to negative. This change was partly due to the agency's assessment that the banks would not be able to comply with new international regulatory requirements, and partly due to the worsening economic conditions in the country caused by the fall in oil prices. The agency noted that these factors would weigh down on the banking sector in Bahrain for the following year — until 2016 or until international oil prices rose again or stabilized near pre-2014 levels. Moody's made this assessment in its report entitled "Banking System Outlook: Bahrain."

Bahraini banks are thus caught in a vicious circle where a number of interrelated factors are affecting one another and collectively weighing on the sector. With the new banking regulations set to be introduced from January 1, 2019, there is limited time for Bahrain's banking sector to prepare for compliance. One major requirement is to reduce exposure to any single sector. Bahraini banks have very high exposure to the oil and petroleum sector, and restructuring those exposure levels so quickly could prove exceedingly difficult. International oil prices remained very low even nearly a year after Moody's downgrade, meaning banks continued to suffer the consequences, with the over-exposure to the oil sector persisting as a significant obstacle to compliance with new international banking regulations.

Compounding matters further, U.S. regulations restricting how American banks deal with foreign institutions have reduced Bahraini banks' access to dollars. This has impacted the operations of Bahraini banks active in the U.S., as well as U.S. banks operating in Bahrain or maintaining ties with Bahraini banks. All of these factors are interrelated and continue to pull against one another, generating strong headwinds for Bahrain's banking sector.

Additional regulatory problems have been induced by the slowing domestic economy, which grew at approximately 2.7% in 2015, down from 4.5% in 2014 — a decline driven by reduced government spending in response to lower oil prices. This dampened the operating conditions for banks and weighed modestly on their funding and profitability. The credit profiles of Bahraini banks have also worsened rather than improved, given their close linkage to the deteriorating fiscal position of the Bahraini government. The government's direct holdings of securities and loans have weakened, and these comprise a significant portion of the banks' equity.