* Gulf aid supports investor confidence in Bahrain
* Decline in banking assets has been modest
* Number of licensed financial firms stable
* But unrest still overhangs any future growth
* Questions over ability to fight off competition
By David French
MANAMA, Feb 20 (Reuters) - When Ahli United Bank, Bahrain's largest lender by market value, announced this week a rise in profits for 2012, it was more than good news for the bank alone. It was a sign that the island kingdom is surviving as a regional financial centre.
Two years after pro-democracy protesters inspired by the Arab Spring uprisings blockaded Bahrain's financial district, political tensions still weigh on its banking industry. This is deterring some investment and inflows of money, and making it harder for Bahrain to compete with other centres such as Dubai.
But contrary to fears at the time, a mass exodus of financial firms from Bahrain has not happened and local banks are proving resilient, allowing the island to remain a hub for financial services in the Gulf.
Bahraini authorities have mounted an active campaign to persuade financial institutions to stay in the country. Economic support to Bahrain from Saudi Arabia and other Gulf states, which are politically allied to the Bahraini government, has helped that campaign.
"Though Bahrain's 2011 political crisis weakened growth potential and damaged the country's reputation as a business services hub, we believe a post-crisis status quo has been established," Standard & Poor's said in late January as it upgraded the outlook for Bahrain's credit rating, a low-investment grade BBB, to stable from negative.
The survival of Bahrain's financial industry is important to the country of about 1.3 million people; its oil resources are not as lavish as those of some of its Gulf neighbours.
Bahrain's financial sector makes up 17.1 percent of its economy, which had an output of $29 billion in 2011, according to the latest central bank figures. The industry is a major employer of local citizens, with Bahrainis accounting for 66 percent of the sector's workforce.
When protests closed down Bahrain Financial Harbour in the days following the outbreak of unrest on Valentine's Day 2011, forcing bankers to work from other locations, the fear was that many might never come back.
The protests were put down by force but sectarian tensions between majority Shias and minority Sunnis have persisted, with skirmishes between angry youths and security forces in villages outside the capital still reported almost daily.
Political talks began on Feb. 10 in an effort to end the deadlock, but there have been few signs of progress so far. Two people were killed on the second anniversary of the uprising.
Some banks did choose to leave the island in the aftermath of the uprising. The biggest blow was the departure of France's Credit Agricole, which said in late 2011 that it was moving its regional headquarters and about 60 staff to Dubai.
Japan's Bank of Tokyo-Mitsubishi moved most of its people to Dubai in mid-2012, leaving a small presence behind.
However, worries about a disastrous hollowing-out of Bahrain's banking industry were misplaced.
Assets in Bahrain's banking system have fallen to $194.9 billion last November from $222.2 billion at the end of 2010, just before the uprising. This contrasts with growth in other Gulf countries such as Saudi Arabia and Qatar, but does not suggest a mass pull-out of money from the country.
The number of banks and financial institutions licensed in Bahrain has remained roughly steady; it was 407 at the end of the third quarter of last year, against 406 at end-2010, central bank data shows.
A trickle of departures has also been offset by the granting of new licences, some to foreign institutions; 14 licences were awarded in 2012. Global asset manager PineBridge Investments opened its Middle East headquarters in Manama last month.
"They've done a good job preventing a mass exodus of financial firms," said Jeffrey Singer, chief executive of the body managing the rival Dubai International Financial Centre.
Many factors are behind Bahrain's survival. Abdulkarim Bucheery, chairman of the Bahrain Association of Banks, an industry body, cited an established infrastructure and regulatory framework and a qualified local workforce.
Bahrain benefits from hosting the headquarters of the influential Accounting and Auditing Organisation for Islamic Financial Institutions, whose standards are used in whole or in part by regulators of Islamic finance around the world.
Boyd Winton, director of financial services at Bahrain's Economic Development Board, said the island could co-exist with rapidly expanding centres elsewhere in the region. He noted that London, Paris and Frankfurt all worked as banking hubs despite their proximity.
"Just because one place is a financial centre doesn't mean another place can't have a financial industry," he said.
Pledges of financial support from Bahrain's wealthy Arab neighbours have helped; those countries undertook in March 2011 to provide a combined $10 billion in aid over 10 years. This appears to have reassured Saudi and other foreign depositors in Bahrain that it is safe to keep money there.
Ahli United Bank, which saw its 2012 net profit climb 8.1 percent to $335.7 million, is among several Bahraini banks that have so far announced higher 2012 earnings. In a report last week, the government said bank lending began to pick up last year, setting the stage for strong economic growth in 2013.
"I think 2012 will start to see the beginning of the growth cycle...and I think 2013 will be building on that growth," said Bucheery, also chief executive of local lender BBK.
However, there is a split between the health of local, retail-focused banks and Bahrain's investment houses, which mostly operate under Islamic principles.
These firms relied on fees from arranging local real estate deals and are struggling to reinvent themselves after the uprising compounded the collapse of the property market. One of the most prominent examples is Gulf Finance House, which has required multiple debt restructurings since 2010.
The central bank of Bahrain has been active in recent months in trying to strengthen these institutions, asking them to increase capital, encouraging revenue diversification and, in some cases, merge, Winton said.
Nevertheless, the future health of Bahrain as a banking market will not be assured as long as the political unrest continues. Ahli United's chairman Fahad al-Rajaan said the bank's 2012 profit growth came despite a "continuing uncertain and challenging business and operating environment", which would persist into 2013.
Although the current, relatively low level of unrest rarely has a direct impact on the lives of expatriate bankers in Bahrain, it is not an incentive to relocate families to the island. Tight, time-consuming screening of travellers arriving at Bahrain's airport because of heightened security concerns could interfere with business travel.
And the unrest may make it harder for authorities, preoccupied with the political crisis, to respond to financial competition. S&P said in its January report that there had been a "relegation of economic policymaking" in Bahrain since 2011.
Dubai, which has over twice as many registered financial firms as Bahrain, hopes to take advantage. Last month, it launched a drive to become the global centre for Islamic finance regulation - a direct challenge to Bahrain's dominance.