The Gulf banking industry has come a long way since the heady days of the late 1970s and early 1980s. Then, petrodollars flooded out of the region into any investment that could absorb them. Banks from around the world hurried to Bahrain to try and mop up some of the capital flows for their own balance sheets, while a new generation of offshore Arab banks came into being.

Nearly two decades on, the banking scene in the Gulf's main financial centre is a much quieter one. The collapse of oil prices in 1986 and the Third World debt crisis were followed by the Iraqi invasion of Kuwait in 1990. Some of the foreign banks pulled out of Bahrain, while many Arab institutions found themselves weighed down with bad loans. There has been a slow decline in the size of the offshore banking sector: in June of this year there were 48 offshore banking units (OBUs) compared to a peak of 75 in the mid-1970s. The OBUs' total assets in June stood at $61,500 million, down from a high point of $72,600 million in 1989.

Although some banks have left, there is a hard core which has remained. 'In the 1970s and 1980s, the vogue was to come to Bahrain and many came for the wrong reason: to take the liquidity and fly it back,' says one Arab investment banker. 'Banks that came after petrodollars found that the dollars disappeared and they had to go back. Banks that provide a range of services remain, and do well.'

A recent report by Moody's Investors Service, the US credit ratings agency, argues that Bahrain's future is as a regional rather than a global financial centre. The decline in capital outflows from the Gulf and the development of 24-hour trading in the last decade have reduced its appeal as an offshore centre for international banks. There is evidence for this in the news that two major foreign banks are to close their treasury operations in Manama. Another, the French-Saudi joint venture Gulf Riyad Bank, may close its doors by the end of this year.

In a generally downbeat assessment of Bahrain's prospects, Moody's also argues that other financial centres in the Middle East, notably Dubai, are increasingly posing a competitive threat, while local political problems have hurt the island's image.

'To many expatriate bankers, homely Bahrain does not compare to picturesque Dubai, which is threatening to challenge the supremacy of Bahrain as the financial centre of the Gulf. Recent political unrest has not helped Bahrain's cause,' writes Moody's in its analysis. 'Moody's believes that... the outlook for the banking industry in Bahrain is less than promising.'

Yet, Bahrain still has a lot of appeal as a financial centre, although the focus of banking activity may be narrower than in the past. It is still the location of choice in the Gulf for investment banks and Islamic financial institutions. The country's domestic banks are currently doing well, though their future is directly tied to local economic and political events in Bahrain in a way that the offshore banks' is not (Bahrain, MEED Special Report, 22:11:96).

Rival contenders

Moody's notes, and bankers concur, that Bahrain's financial industry is well-regulated by the Bahrain Monetary Agency (BMA - central bank). It is also closer than Dubai to the region's largest market, Saudi Arabia. Dubai's excellent infrastructure and importance as a trading centre make it attractive to some commercial banks which want a representative office in the Gulf, but Bahrain's greater experience of banking may give it the edge. Beirut is an outside contender, but its appeal as a financial centre remains to be proven.

Most bankers in Manama expect Bahrain to retain its leading position. 'I don't see a change,' says Citibank's Gulf and Levant chief Mohammed Shroogi, echoing a view expressed by several other executives. 'There are 180 banks here. People talk about Dubai and Lebanon, but I don't see it. The main thing a bank wants to see is a strong regulator, and Bahrain has that.' Another banker points out that a de-facto division of labour seems to have evolved between the Gulf states: Bahrain is not a significant oil producer or a trading centre, so it hosts the banks instead.

Global consolidation

Bankers point out that although there has been a decline in the number of foreign banks operating on the island, this is often due to consolidation in the worldwide banking industry, rather than a reaction to local difficulties in the Gulf. For example, US banks Manufacturers Hanover, Chemical Bank and Chase Manhattan Bank all had a separate presence in Bahrain at the start of the decade. After the successive mergers that have brought the three banks under a single roof, only the Chase office remains.

The two European banks that are closing their treasury units, Swiss Banking Corporation and Banque Indosuez, are doing so because the business can be run just as well from London or Singapore. Both are keeping representative offices for their other banking business and stress that they want to stay in Bahrain.

Bahrain will remain the home for two of the Arab world's top 10 banks, Arab Banking Corporation and Gulf International Bank, as well as specialised banks like Investcorp, which invests Gulf money overseas. Investcorp, one of the best performers in Arab banking, has thrived since 1982 by sticking to a single formula - using its formidable capacity to raise money from Gulf investors to focus on mergers and acquisitions (M&A) in Europe and the US.

The Investcorp model has made a great impression on other banks in Bahrain and earlier this year a group of international investors, including a Saudi prince, announced plans for an M&A house that will do in Asia some of the things that Investcorp is doing elsewhere.

Another line of business that Bahrain can do well out of is Islamic banking. Until this year there were about half a dozen Islamic institutions in Bahrain, including one domestic bank. The Dar Al-Maal Al-Islami group, a worldwide Islamic financial conglomerate based in Geneva, has developed a strong presence on the island through two subsidiaries, Islamic Investment Company of the Gulf and Faysal Islamic Bank of Bahrain.

This year has seen a further expansion of the sector with the opening of an Islamic banking subsidiary by global giant Citibank. ABC is also planning an Islamic bank in which it would have a minority stake. The new venture, Islamic Finance Corporation, will incorporate ABC's existing Islamic banking services. GIB is considering setting up its own Islamic bank, while a group of Kuwaiti and Saudi investors has set up another new venture, First Islamic Investment Bank. The latter aims to provide global investment and corporate finance services: bankers say that its initial focus is likely to be on southeast Asia. ABN AMRO has plans for its own dedicated Islamic subsidiary, though bank officials say there has been little progress on the project this year.

The advent of conventional banks with their larger resources could be seen as a threat to the existing Islamic banks. For its part, Citibank says it aims to get business by enlarging the size of the market with new products and services rather than by taking existing business away from other banks.

ABC's project may be less contentious, partly because the majority of the shares will be owned by other Islamic banks and partly because its main emphasis will be on providing other banks with facilities for short- term liquidity management. In the case of both ABC and Citibank, there is an argument that because Islamic banking is still growing, the market can only gain from the arrival of prestigious names with technical skills honed in other fields.

Bahrain has endured as a financial centre despite the drying up of the petrodollar flows which brought it into existence. The financial sector has shrunk in asset terms since the 1980s and it remains vulnerable to the ups and downs of a region that is regarded as unstable and unpredictable. Nonetheless, the evidence of this year shows that given its track record, Bahrain will retain its attraction for many banks in the future.