Covering only 25 square kilometres, Manama is home to almost 400 financial services institutions, and more are on their way. In October, the Central Bank of Bahrain (CBB) licensed four institutions including an insurance company, an investment subsidiary of a Saudi Arabian bank, India's Bank of Baroda, and the newly established Islamic Bank of Asia.

As the lynchpin of the non-oil sector economy, financial services account for one-quarter of Bahrain's gross domestic product (GDP), according to the Central Bank of Bahrain (see table). It is also a significant employer, with Bahrainis taking up more than 70 per cent of positions at the financial institutions. Much is riding on the growth of the sector and Bahrain is fighting to retain its title as the Middle East's financial hub.

“Until about six or seven years ago, Bahrain was the undisputed financial capital in the region,” says a Bahrain-based banker.

This has changed since the launch of the Dubai International Financial Centre (DIFC) in 2004, its most serious challenger, and the birth of the Qatar Financial Centre in early 2005.

But if Manama loses ground to its rivals, Bahrain's economic diversification plans will suffer a significant blow. Oil is still an economic driver, accounting for 25 per cent of GDP and 75 per cent of revenues in 2005, but it is running out. Proven oil reserves stood at 125 million barrels in January 2007. The government is relying on the financial sector to make up for this.

Alternative sectors
“There is not another sector that can replace financial services,” says Jithesh Gopi, head of research at Bahrain-based Sico Investment Bank. “The closest one is tourism. It is a problem.”

The vast majority of firms in Bahrain are investment and insurance firms conducting offshore, wholesale business that are restricted in their domestic offering. Bahrain and Dubai are competing to attract their attention.

Bahrain's key advantage is its regulatory environment, which is one of the most developed in the region. It has had a head start having established a reputation as a financial centre more than 30 years ago, taking the mantel from Beirut.
“We chose Bahrain over Dubai because we are comfortable with the regulatory framework,” says Firas Mallah, head of Middle East at Europe's Dexia Asset Management. “We started looking two years ago and it was not clear then what the regulatory framework was in Dubai.”

But the regulatory regime at the DIFC is catching up, and it has overtaken Bahrain as the location of choice for some international firms.

This is despite the reduced cost of setting up in Manama, where inflation is in low single digits, compared with rising prices in the UAE. And unlike the offshore DIFC, there are no restrictions on where institutions can be located.

The Bahrain Financial Harbour development is a symbol of the kingdom's ambition to remain the financial capital of the region, but firms are not obliged to set up within the complex.

Dubai is also challenging Bahrain's reputation as the regional centre of Islamic finance.

Currently, Manama is home to the largest concentration of sharia-compliant institutions in the region, with 29 Islamic banks and 15 Islamic insurance companies. It also boasts a trio of regulatory bodies established to advance the sector.

Here, as in the conventional market, Bahrain has capitalised on its proximity to Saudi Arabia. Business from Saudi Arabia is channelled through Manama, where, for instance, there are no restrictions on setting up a special purpose vehicle to issue a sukuk (Islamic bond), as required under the popular ijara or lease-back structure.

Local bankers estimate more than 50 per cent of Manama's financial sector business comes from Saudi Arabia. But this reliance on business from the kingdom is also a weakness.

Riyadh's quest to develop its own banking sector poses a long-term threat to Bahrain.

Saudi Arabia's Capital Market Authority has ramped up the licensing of international institutions to undertake investment banking, brokerage and wealth management activities. In addition, the kingdom plans to develop a financial centre at King Abdullah Economic City (KAEC).

Expanding city
“As they expand KAEC, at some point those institutions that benefit from being in Manama will find it more beneficial to be in Riyadh,” says Tarek Fadlallah, executive director of Bahrain-based Nomura Investment Banking.

“Saudi Arabia has made it clear that if you want to operate in the kingdom you have to be there. Bahrain is vulnerable to Saudi Arabia rather than Dubai or Qatar.”

However Bahrain has a considerable head start on its neighbour, and firms continue to flock to Manama.

It also has a much more mature and well understood regulatory system, demonstrated in November when the central bank governor accused some institutions of unethical behaviour, for specu-lating over the whether the country was to abandon its currency peg to the dollar.

The confidence this creates will stand Bahrain in good stead as it continues to expand its most critical economic revenue stream.