Bahrain's financial sector is well developed and diversified, consisting of a wide range of conventional and Islamic financial institutions and markets, all of which are subject to a sophisticated legal and regulatory framework.
Bahrain (through the Central Bank of Bahrain (CBB)) has one of the most comprehensive regulatory regimes for regulating shariah-compliant activities in the world. Oman and Pakistan are close competitors, though Malaysia is generally regarded as having the most comprehensive. The difference is that Oman and Pakistan have separate legislation dealing with sukuk issuances (as does Jordan), but other legislation in those jurisdictions either does not fully cater to non-commercial banking and capital markets activities or is quite nascent.
The CBB's legislative model differs from Oman and Pakistan in that it is less prescriptive and allows financial and other institutions to align their businesses with rapidly fluctuating global trends. This means the CBB maintains an open dialogue with all its licensees and regularly seeks their (and other market participants' input) on legislative updates and further regulation. This is one of the features that distinguish CBB's approach to regulation from the rest of the regulators in the Gulf Cooperation Council (GCC).
The term 'Islamic finance' or 'Islamic banking' in Bahrain has wider application than just applying to commercial banks and includes non-deposit-taking investment or merchant banks and private equity institutions operating in a shariah-compliant manner. The CBB licenses each of these institutions appropriately in accordance with their proposed activities. The ambit of this chapter does not include a discussion on each of these licences, as this information is available on the CBB's website.2
II LEGISLATIVE AND REGULATORY FRAMEWORK
i Legislative and regulatory regime
Persons wishing to undertake regulated Islamic banking services must be licensed by the CBB as an Islamic bank licensee. Regulated Islamic banking services consist of three determinant activities: (1) accepting shariah money placements or deposits; (2) managing shariah profit-sharing investment accounts; and (3) offering shariah financing contracts. If an institution has the requisite licence, it may be able to offer all three regulated activities alongside various supplementary activities. Islamic bank licensees must operate in compliance with shariah economic principles and only Islamic bank licensees may hold themselves out to be fully shariah-compliant institutions. Ultimately, it is the type of licence issued by the regulator that determines whether an institution is shariah-compliant.
Every individual Islamic bank in Bahrain has its own internal shariah board, which determines the shariah compliance of its products. In December 2018, there were 382 institutions and 98 retail banks registered in the banking sector, of which 21 were Islamic banks licensed by the CBB. The CBB does not interfere with this internal process but is usually very helpful and facilitates discussions about new ideas and concepts. The CBB must approve new products before they can be offered to customers. The banks also need to inform their customers of associated risks and any unusual product features if the capital is not protected. If the capital is protected then the banks must inform the customers that there is a chance that the actual return may be lower than the anticipated or projected return.
Islamic bank licensees are divided into two subcategories: Islamic retail banks and Islamic wholesale banks. Specific regulatory requirements may differ between these two subcategories where appropriate to address their risk profiles.
Islamic retail banks may undertake transactions in any currency, with both Bahraini residents and non-residents. To qualify as an Islamic retail bank, the activity of offering shariah financing contracts must account for a significant portion of the institution's business. This is defined, broadly, as accounting for over 20 per cent of an institution's assets.
Islamic wholesale banks may also undertake transactions without restriction when dealing with the government of Bahrain and its agencies, CBB bank licensees and non-residents. However, they may only undertake transactions denominated in Bahraini dinars or with a resident of the Kingdom of Bahrain if these transactions are to be wholesale in nature. Wholesale transactions are defined in terms of transaction size (broadly, 7 million dinars or more for the activities of accepting shariah money placements or deposits and offering shariah financing contracts, and US$100,000 or more for any of the other activities falling within the definition of regulated Islamic banking services). Islamic wholesale banks are allowed to transact in dinars (or any other currency) for any amount with the government of Bahrain, Bahrain public sector entities (as defined in the guidelines for completion of the Prudential Information Returns for Islamic Banks Form) and CBB bank licensees. Islamic wholesale banks may also transact in dinars for any amount (where required) to fund their normal operating expenses when investing for their own account in securities listed on a licensed exchange.
Islamic bank licensees are subject to certain licensing conditions. These licensing conditions are consistent with international good practice, such as the relevant Basel Committee and Islamic Financial Services Board standards.
Islamic bank licensees must satisfy the CBB that their controllers are suitable and pose no undue risks to the licensee. There are also certain procedures, as set out in Articles 52 to 56 of the Central Bank of Bahrain and the Financial Institutions Law (the CBB Law)3 on controllers. Licensees and their controllers must also observe the CBB's capital markets requirements in respect of changes in holdings of shares of listed companies. There are differing requirements for locally incorporated licensees (Bahraini Islamic bank licensees) and branches of foreign banks (overseas Islamic bank licensees). Requirements for overseas Islamic bank licensees are less onerous than those for Bahraini Islamic bank licensees.
A licensee that carries on an activity such as dealing in shariah-compliant financial instruments as agent (i.e., buying, selling or subscribing for shariah-compliant financial instruments on behalf of a client) should not determine the terms of the transaction and should not use its own financial resources for the purpose of funding the transaction. This means that the licensee must act as an agent and must not have a say in the terms of the transaction. Such a licensee may, however, receive or hold assets in connection with the transaction in its capacity as agent of its client. The following are examples of activities that, when taken in isolation, are unlikely to be regarded as acting in the capacity of an agent:
- appointing professional advisers;
- preparing a prospectus or business plan other than in connection with the Regulatory and Supervisory Module on Issuing and Offering of Securities and Sharia Compliant Sukuk of 2013 (the OFS Module);
- identifying potential sources of funding;
- assisting investors, subscribers or borrowers to complete and submit application forms other than in connection with the OFS Module, the CBB Rulebook Volume 6 (Capital Markets) and the CBB Rulebook Volume 7 (Collective Investment Undertakings); or
- receiving application forms for processing or checking and onward transmission other than in connection with the OFS Module, the CBB Rulebook Volume 6 (Capital Markets) and the CBB Rulebook Volume 7 (Collective Investment Undertakings).
Islamic bank licensees must maintain a minimum daily cash reserve balance with the CBB, set as a ratio of their total non-bank dinar funds, whether placed by way of call or unrestricted investment accounts (or similar), as well as taken through the issuance of dinar-denominated Islamic investment certificates. The current required ratio is 5 per cent and may be varied by the CBB at its discretion.
Islamic bank licensees must arrange for their external auditor to confirm the accuracy of the data reported on the eligible accounts report for the deposits or unrestricted investment account protection funds.
ii Regulatory and supervisory authorities
Conventional banks and shariah-complaint banks (referred to collectively as licensees) are both regulated by the CBB; however, the rules for each differ. The accounting standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) are compulsory for all Islamic banks and for conventional banks if they are maintaining Islamic units.
The CBB's supervision of licensees is a mixture of on-site assessment (including the quality of systems and controls, and of books and records) and off-site supervision (which focuses on the analysis of regulatory returns, as well as of audited financial statements and other relevant public information). The CBB strengthened its supervisory role by establishing a centralised Shariah Supervisory Board in 2015 and launching the shariah governance framework, which became effective in June 2018.
On-site examinations are undertaken by the CBB's own examiners, as well as by experts appointed for the purpose by the CBB (such as accountants and actuaries). Off-site supervision also includes regular prudential meetings with licensees to review performance, strategy and compliance matters (such as capital adequacy, large exposures and liquidity).
For banks, a risk profiling system has been developed to underpin the above supervisory efforts, by providing a detailed framework for assessing the impact and risk profile of individual licensees and prioritising subsequent supervisory efforts. Work is under way to extend this profiling system to insurance companies.
Should a licensee fail to satisfy the CBB's regulatory requirements, then the measures outlined in the enforcement modules of the applicable volumes of the rule book may be applied. Enforcement measures include formal warnings, directions (e.g., to cease or desist from an activity), formal requests for information, adverse fit and proper findings, financial penalties or investigations. Extreme violations of the CBB's regulatory requirements may entail cancellation of a licence, putting into administration or criminal sanctions.
III COMMON STRUCTURES
|Types of product offered4||Description of product|
|Mudarabah savings account||A mudarabah savings account is based on the shariah principle of 'unrestricted mudarabah'. Under the mudarabah principle the customer will act as a capital provider and the bank will act as a mudarib (entrepreneur) using its expertise. The bank pools all customer funds with its own capital and invests it in shariah-compliant modes of investments. The resulting profit is shared between the bank and customers according to predetermined ratios. Mudarabah is a profit-and-loss sharing product and the better the bank performs, the higher the profits earned.|
|Term investment deposit (mudarabah)||Term investment deposit is based on the shariah principle of unrestricted mudarabah. Under the mudarabah principle the customer is an investor (rab-al-mal) for a fixed period and the bank will act as a mudarib (entrepreneur) using its expertise. The bank pools all customer funds with its own capital and invests it in shariah-compliant investments for a specified investment term and expected profit rate. The resulting profit is shared between the bank and customers according to predetermined mutually agreed ratios.|
|Izdihar savings account||An izdihar account is a savings account based on the Islamic principle of unrestricted mudarabah, which means customers can earn profit on their savings. Funds are placed in a common investment pool where they are invested in strict compliance with shariah principles to generate the best possible returns. Profits generated from the investments are shared between the bank and the customers according to a pre-agreed profit-sharing ratio.|
|Current account (qard hasan)||The current account is based on the Islamic contract of qard hasan (interest-free loan). You as a depositor will be the lender and the bank will be the borrower. The deposited funds are invested in halal activities only. Irrespective of the profit or loss generated by the bank from the investments, the funds are guaranteed payable on demand without any profit or penalty.|
|Wakalah investment||Wakalah investment is based on the Islamic concept of wakalah istithmar, under which you become the principal (muwakkil) and the bank becomes the investment agent (wakeel) of your funds. The bank invests these funds in shariah-compliant financing and investment activities. The targeted profit earned from the investments is distributed to the customers upon maturity of the account. The bank (as wakeel) deducts its agreed agency fee (wakalah fee) and, at maturity, pays both the targeted profit amount and the principal funds to the customers as per the terms of the wakalah agreement.|
i Private equity investments
In Bahrain and from Bahrain private equity funds, whether they are to be established in a shariah-compliant manner or generally established as a conventional fund, no particular structure is used.
Common structures would be Cayman Islands exempt limited partnerships (if in the form of a partnership or a Cayman Islands exempt corporate fund). The investment may also be set up in Bahrain as a private investment undertaking. This is a flexible type of fund that only needs to be registered with, rather than approved by, the CBB, and that has very limited restrictions on its ability to invest, although there are very high thresholds on the type of investor and the minimum investor amount in respect of investing in such a fund.
In general, any fund that is to be shariah-compliant would have to obtain a fatwa and make its investments in shariah-compliant products and in compliance with the various tenets of shariah.
ii Real estate investments
In respect of real estate funds, no particular structure is used and the same considerations in respect of a conventional fund would be taken in establishing a shariah-compliant real estate fund.
The common structures are offshore limited partnerships and companies, locally domiciled funds and real estate investment trusts. The Trust Law Bahrain5 was introduced in late 2016, enabling the establishment and listing of real estate investment trusts, known as Bahrain real estate investment trusts (BREITs).
BREITs can be established as either an expert collective investment undertaking (CIU) or an exempt CIU. Expert CIUs may be offered only to expert investors, who must deposit a minimum of US$10,000. Exempt CIUs are lightly regulated but may only be offered to accredited investors who invest at least US$100,000. BREITs are gaining more attention in Bahrain, though very few have been launched to date.
GCC nationals and wholly owned GCC entities may own land in Bahrain on a freehold basis. A non-Bahraini person or legal entity can own real estate or land in certain designated areas where foreign ownership is permissible.
iii Investment funds
Investment funds are generally established in Bahrain as companies, partnerships or trusts. No particular type of fund structure is used to enable it to be shariah-compliant.
A common structure used when the fund is to be marketed to retail investors would be a shariah-compliant expert fund. This type of fund requires a minimum investment of US$10,000 and can only be offered to investors who already hold financial assets of at least US$100,000. Expert funds can be leveraged by borrowing up to a limit of 20 per cent of the value of assets under management.
A further example of a type of investment fund used in Bahrain is a shariah-compliant exempt fund. This can only be marketed to accredited investors (who already hold assets worth US$1 million) and the minimum investment amount is US$100,000. This type of fund is lightly regulated.
Bahrain introduced the Investment Partnership Law6 in 2017 and in doing so is the first country in the GCC region to have introduced national legislation enabling the formation of limited partnerships in a manner comparable to structures utilised in reputable offshore fund domiciles. Key features of the new Law include the ability for a general partner of a Bahrain investment limited partnership to be established as a subsidiary or a special purpose vehicle of an investment business. This would allow sponsors not to be unduly exposed in terms of liability and while using one of the preferred and widely recognised international models for private equity funds. The new Law also aims to make Bahrain a more attractive market for investors by setting a high liability standard in respect of general partners.
The Protected Cell Companies Law,7 enacted in Bahrain in 2016, allows for the formation of protected-cell companies (often called segregated portfolio companies or sub-funds). Both a limited partnership fund and a segregated portfolio fund can be established as a shariah-compliant fund. A protected-cell company is a corporate structure in which a single legal entity is comprised of a core legal entity under which there are several divided cells or portfolios. The protected-cell company allows for each cell to be managed by a single or separate investment manager. As a fund develops, expands and targets under or varying asset classes, new cells can be established, which enables long-term flexibility and provides opportunities for investors to be exposed to new asset classes or sectors at lower costs for the fund promoter or manager. Each cell's assets can be ring-fenced and are therefore only available, or exposed to, the creditors and shareholders of each particular cell. The development of this Law signifies a will to develop the funds industry in Bahrain.
As at the end of June 2019, the number of mutual funds stood at 2,136, of which 74 were Bahrain-domiciled, compared with 2,290 funds as at June 2018. The number of shariah-compliant funds stood at 80, as at June 2019.8
The Trust Law Bahrain replaced the Bahrain Financial Trusts Law of 2006 and aims to provide detailed guidance on the creation and administration of financial trusts within the Kingdom. While such trusts are widely used in other jurisdictions, they are new to the Middle East and Bahrain is one of the first countries to put in place this type of legal framework. It is anticipated and hoped that these updates will allow for the development of onshore shariah-compliant structures to hold assets, particularly for families who have previously tended to use offshore jurisdictions to do so. These trusts are also used in the development of BREITs, which can be established pursuant to the CBB fund regulations.
Bahrain currently has no income tax, corporation tax (except for oil, gas and petroleum companies that are engaged in exploration, production or refining, regardless of their place of incorporation) or capital gains tax and no estate duty, inheritance tax or gift tax. However, Islamic finance transactions involving real estate may be subject to taxes. For example, if the legal ownership of the land is transferred or registered, this could result in registration fees. On all property purchases, a registration fee of 2 per cent is levied, which is reduced to 1.7 per cent if registration and payment are completed within 60 days of the relevant transaction. If an Islamic financial transaction involves payments under an ijarah, this will generally not be subject to taxation. In Bahrain, Islamic finance transactions typically involve no actual movement of legal ownership and only the economic or beneficial value or ownership is transferred, which is not subject to any taxes.
Under existing Bahraini laws, payments under the bonds, sukuk or notes will not be subject to taxation in Bahrain, no withholding will be required on such payments to any holder of notes, and gains derived from the sale of notes will not be subject to Bahraini income, corporation or capital gains tax. In the event of the imposition of any withholding, the issuer will have undertaken to gross up any payments subject to the withholding.
Following an extraordinary meeting of finance ministers in Jeddah in June 2016, the GCC countries approved the introduction of value added tax (VAT) in the GCC. Bahrain signed the GCC Unified VAT and Excise Treaties on 1 February 2017 and brought into effect on 1 January 2019 the Bahrain VAT Law.9 A new tax authority, the National Bureau for Revenue, has been set up to oversee the VAT regime and is responsible for the registration and assignment of those subject to VAT, and for enforcement of VAT-related obligations.
VAT has been introduced at the standard rate of 5 per cent although some supplies are zero rated, exempt from VAT or outside the scope of VAT. VAT has been introduced on a staggered basis depending on the size of a business's turnover. Businesses with annual turnover exceeding 5 million dinars became subject to VAT from 1 January 2019, businesses with turnover of between 500,000 and 500 million dinars became subject to VAT from 1 July 2019, and businesses with turnover of 37,500 to 500,000 dinars will become subject to VAT from 1 January 2020. Businesses below the 37,500-dinar threshold but with a turnover above 18,750 dinars are entitled to voluntary registration if desired.
There can be no doubt that from a commercial and legal perspective the introduction of VAT heralds a significant development in the region. The new VAT regime is consumer-friendly with zero ratings for basic necessities such as healthcare, education, basic food items and the construction of new buildings, both residential and commercial properties. The introduction of VAT by GCC governments will be regarded by many as a constructive measure to assist, diversify and strengthen those countries' respective fiscal revenue streams in an era of falling oil prices; and to promote economic stability in the long term. It is important to note in this regard that the International Monetary Fund has previously encouraged the GCC countries to introduce VAT.
Islamic financial transactions are generally exempt from VAT if the income earned by the supplier is by way of interest, a profit margin akin to interest, or by way of an implicit margin. However, fees, commissions or commercial discounts received by Islamic finance providers are not exempt and are subject to VAT at the standard rate of 5 per cent.
As with the introduction of VAT in Saudi Arabia and the United Arab Emirates from 1 January 2018, and on account of its staggered introduction, it is taking some time for businesses and the tax authorities to absorb the changes. It is currently too early to judge, but it is hoped that the Bahrain tax authorities will operate with a light touch during this introductory phase.
It is also notable that VAT has been introduced as part of a GCC-wide customs union. Therefore, it is vital that the design of local regimes takes this customs union into account, to avoid overload and unnecessary complexity for governments and businesses alike.
There is no separate insolvency regime for Islamic finance in Bahrain. The Bankruptcy Reorganisation and Bankruptcy Law (the Bankruptcy Law)10 and the Commercial Companies Law,11 as amended, apply to bankruptcies, reorganisations and insolvency matters in Bahrain. There are separate insolvency rules for financial institutions licensed by the CBB under the CBB Law. Following the consultation period during which all CBB licensees, listed companies in Bahrain, law firms and audit firms provided their feedback, the Bankruptcy Law came into effect on 8 December 2018, replacing the Preventative Composition Law.12 The Bankruptcy Law does not apply to those licensed by the CBB and therefore does not apply to Islamic finance services.
VI JUDICIAL FRAMEWORK
Bahrain has a dual court system, consisting of civil and shariah courts. Shariah courts deal primarily with personal status matters (such as marriage, divorce and inheritance). Shariah courts of first instance are located in all communities. A single shariah Court of Appeal sits at Manama. Appeals beyond the jurisdiction of the shariah Court of Appeal are taken to the Supreme Court of Appeal, which is part of the civil system.
The shariah acts only as a 'guiding principle' and as such the terms and conditions of Islamic finance products are determined by national laws. In Bahrain, disputes revolving around Islamic finance contracts and products are heard before the civil courts.
Islamic finance is on the rise in Bahrain and internationally, although annual growth of up to 15 per cent per year as seen in recent years is unlikely in the near future. A recent report13 estimates that Islamic finance assets will reach US$3.8 trillion by 2023, which equates to an average projected growth of 10 per cent per year. His Excellency Rasheed Mohammed Al Maraj (governor of the CBB) predicts 5 per cent annual growth over 2018 and 2019 for the Middle East Islamic banking sector.
Bahrain is growing in influence as a leading centre of innovation for Islamic finance. A number of amendments were made to the CBB's codes and rules between 2014 and 2019, with the aim of promoting best practice and on the basis of certain rulings of the primary global committee of banking supervision (the Basel Committee).
At present significant moves are being taken to strengthen banks' capital bases and to promote transparency and better governance. Banks in Bahrain are being encouraged to consider merging to strengthen themselves and compete more effectively. Several Islamic lenders have already merged (e.g., the three-way merger of Capivest, Elaf Bank and Capital Management House in 2013) and more mergers are taking place, with the highest-profile of these being the proposed merger of Kuwait Finance House Bahrain with Bahrain's Ahli United Bank, which is expected to be completed by October 2021.
In early 2019, AAOIFI approved a draft regulation on shariah compliance for Islamic finance institutions requiring them to make publicly available information regarding solvency, financial stability and compliance.14 This information could then be used by ratings agencies and investors alike, providing greater transparency and certainty in Bahrain's Islamic finance market.
In early 2019, the Cabinet was debating a controversial draft law that would require all banks operating in Bahrain to become shariah-compliant and would ban non-Islamic finance practices.15 There has been strong opposition to this, given the potential exodus of non-Islamic banks that would result and the subsequent negative impact on Bahrain's financial market.
The Basel Committee recommendations made in light of the global financial crisis have led to a number of reforms and initiatives. Banks are now being asked to be more transparent, for example, by making more useful data available to stakeholders so that they can make informed choices.
These changes have resulted in major reforms. The governor of the CBB has said that 'the overall outcome is that Islamic finance is benefiting from these changes. The over-reliance on real estate and infrastructure projects is being systematically replaced with recognition that fixed income assets, which in turn provide identifiable, sustainable profits for the future, are the way forward.'
The CBB is working with bodies such as the non-profit International Islamic Finance Market (IIFM) to standardise Islamic banking practices further. One of its recommendations has been to ensure that Treasury product transactions are governed by the International Swaps and Derivatives Association (ISDA/IIFM Tahawwut Master Agreement). This agreement is designed to govern the relationship between the parties in a shariah-compliant hedging transaction. The use of these agreements is not mandatory in Bahrain.
The CBB has also urged Islamic banks to have their institutions rated by the Islamic International Rating Agency (IIRA), which has its headquarters in Bahrain. The IIRA ratings inform investors about corporate and shariah governance practices in addition to the financial risk profile of the entity.
The CBB has proposed further rules in an attempt by Bahrain to regain prominence in the Islamic finance industry. In August 2017, the CBB imposed a requirement that Islamic banks should be audited externally by shariah experts rather than be subject to self-regulation. Furthermore, banks would be required to disclose any non-permissible income and state how they intend to dispose of assets generated by non-shariah-compliant earnings or acquired through prohibited expenditure. It has been argued that the current approach allows more diversity and flexibility; however, there is growing support in Bahrain for reforms to increase transparency in this field.
Bahrain is a world leader in Islamic finance, accommodating the largest concentration of Islamic financial institutions in the Middle East. Takaful contributions to the Bahrain market have consistently averaged around 22 per cent, which compares favourably with the likes of the United Arab Emirates, which averages around 16 per cent.16 At present, there are six Islamic takaful insurance companies and two retakaful companies operating in Bahrain. Bahrain is a market leader for Islamic securities (sukuk).
Finally, Bahrain hosted both the 24th and the 25th World Islamic Banking Conference in December 2017 and November 2018 respectively, at which more than 10,000 global leaders gathered to address economic uncertainties and unlock opportunities for sustainable growth in the global Islamic finance industry. These events produced a road map for 2018 and beyond by showcasing new technology and cutting-edge research.
1 Salman Ahmed is a partner and Eleanor Clot is a trainee solicitor at Trowers & Hamlins.
3 Decree No. 64/2006.
4 In relation to certain mudarabah-, wakalah- or musharakah-based savings accounts and products that are not capital guaranteed, it is possible that a customer may not be guaranteed a return and may even lose its principal. The CBB has strict criteria for offering these types of products, including suitable disclosures (i.e., product summary, risk factors, etc.). The customer must therefore assume complete performance risk, although, in practice, it is unusual for the banks not to provide the anticipated profit and return principal.
5 Decree No. 23/2016.
6 Decree No. 18/2016.
7 Decree No. 22/2016.
9 Decree No. 48/2018.
10 Decree No. 22/2018.
11 Decree No. 21/2001.
12 Decree No. 11/1987.
13 'The State of the Global Islamic Economy Report 2017/18', published by Thomson Reuters and the Islamic Corporation for the Development of the Private Sector.