In the wake of the financial crisis, many international regulators have had their reputations tarnished for failing to spot the massive problems that were building up in some of the world’s largest banks.

For Bahrain, which has always prided itself on being one of the best regulated financial centres of the Gulf, the crisis has prompted a fresh look at how it regulates the banking sector. Because it has always been a popular home for offshore banking and Islamic investment banks, it began to view the financial sector in two tiers.

It is now formalising this view. The top tier will consist of the largest domestically focused full-service banks, the other tier will be the rest. The systemically important banks will need to meet tougher requirements to ensure their health in the event of a future crisis. That will help Bahrain to avoid the moral hazard of being obliged to bail-out failing banks.

The smallest of the remaining institutions are already facing pressure from the Central Bank of Bahrain to merge in order to create larger banks better able to cope with shocks. This should also help avoid Bahrain being left with zombie banks unable to raise new funding or exit existing investments.

In the short-term, these measures could hit profitability at Bahraini banks, but given the government’s limited resources and the strategic importance of its financial sector, they could prove to be a wise move by the regulator.