Introduction:

1. 1. Introduction: The Kingdom of Bahrain is the leading financial center of the Gulf region, it has been awarded A-sovereign by Standard & Poors in 2002 and Fitch in 2003. Bahrain as a financial center has grown significantly in the 1970s following the 1973-74 sharp increase in oil price which created the need for an active financial and banking center to recycle the substantial financial surplus of the region. In 1975, Bahrain has taken the lead and invited major international banks to open branches in the island and operate as offshore banking units (OBUs). The response of the international banks to Bahrain’s invitation was overwhelming and the number of OBUs reached 76 in 1984.1 It has since developed a wide range of financial products and services in commercial, investment and corporate banking. Bahrain has also established itself as the leading center for Islamic finance in the Middle East. Bahrain is the host of the largest concentration of Islamic banks in the region. Since 1979, Islamic financial institutions have grown considerably in Bahrain, the consolidated balance sheet of Islamic banks has shown total assets of $8.4 bn in December 2001. Islamic banks complement the activities and operations of other traditional financial institutions, they provide a variety of financial products ranging from traditional Islamic modes of finance such as mudaraba, murabaha, leasing and musharaka to Islamic syndicated finance and collective investment funds. The aim of the study is to examine the performance of Bahrain banking sector and estimate how close Bahrain banks are from their potential profits (profit efficiency) over 1985-2001. This issue is important because the financial sector plays a major role as a key sector in Bahrain’s economy. Financial sector is the largest employer and contributor to the economy, accounting for over 20 per cent of GDP. We also compare the efficiency of Islamic vs conventional banks in Bahrain. So far, there are few empirical papers devoted to Islamic banking. Furthermore, the issue of efficiency in banking is important at the micro and macroeconomic levels since efficiency has important policy implications. In the past, financial institutions used to enjoy local oligopolies and therefore make rewarding profits, but in recent years 1 In 1975, Citibank and Algemene Bank were the first OBUs to operate in Bahrain. 9