The outlook for Bahrain"s banking system remains negative, reflecting expectations that challenging credit and business conditions will continue over the medium term, says Moody's Investors Service.

These expectations are based on the continued weakness in Bahraini and regional real estate and the impact it is having on the rest of the economy, despite  the modest rebound in the economy in 2010, Moody's said in its new Banking System Outlook on Bahrain.

The negative outlook is also driven by (i) ongoing franchise challenges at Bahraini-based wholesale lenders, as they try to refocus their business towards more profitable segments; and also by (ii) the more severe challenges at investment banks, which in many cases do not possess sufficient franchise depth to cope with the sharply lower private investment activity and depressed regional asset values.

Moody's negative outlook for this sector assumes further deterioration in at least some aspects of Bahraini banks' franchises and risk profiles. The rating agency's primary focus will be on possible further increases in non-performing loans, with banks' significant construction and real-estate exposures being an area of particular concern, the report said..

"Our current assessment is that although real-estate loan quality has generally remained robust so far, continued weakness in this sector will eventually feed through to banks' loan portfolios, both directly and indirectly through loan exposures to other sectors of the economy," explains George Chrysaphinis, Moody's analyst and author of the report.

The report notes that with the severity and timing of real-estate-related losses still uncertain, Moody's does not currently believe it is necessary to adjust Bahraini bank ratings downwards, given the rated banks' robust loss absorption capacity. "However, we will continue to monitor the condition of real-estate borrowers in Bahrain and could revise our view if it appears that the size of likely losses could threaten banks" financial health," adds Chrysaphinis.

Despite these negative factors, significant positive factors remain. The strong capitalisation of most retail and wholesale banks provides significant loss-absorption capacity, and most of the retail banks have sound liquidity profiles, it said.

Moody"s acknowledges that although systemic banking risk is an issue in Bahrain, in view of the large size of the banking sector relative to the size of the economy, the regulatory authorities have shown that they are able to contain this risk.

"The stability of the system resides in the clear distinction between the retail and wholesale banking sectors and in the Central Bank of Bahrain's (CBB) fairly robust regulatory and supervisory environment," notes Chrysaphinis. "There is recognition that the wholesale banking category, which also includes investment banks, carries more risk, but that possible bank failures can be isolated because wholesale banks do not form part of the domestic payments system. In this regard it should be noted that the Bahraini authorities have so far not had to provide any material assistance to the retail banking sector, in contrast to regional peers". - TradeArabia News Service