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banking industry faces competitive pressure worldwide as the financial structure changes rapidly. Furthermore, bank efficiency is a socially optimal target since it reduces the average cost of financial transactions and therefore enhances the society’s welfare. The paper proceeds as following: Section two gives an overview of Bahrain’s economy and Section three explains the structure of the banking sector in Bahrain. Section four is devoted to Islamic banking in Bahrain. The discussion of the efficiency concepts is given in Section five. Econometric methodology is explained in Section six. Hypotheses and model specifications are provided in Section seven. Data analysis and empirical results are discussed in Section eight. Then, Section nine concludes. 2. Economy of Bahrain: An Overview The Bahrain economy has doubled in size over the last 15 years, GDP has been growing consistently since 1989. Bahrain has one of the highest average income in the Middle East. In 2000, per capita GDP has reached BD 4343. Bahrain has the highest literacy rate in the Arab world and the longest life expectancy in the region. According to UNDP human development index (2003), The kingdom of Bahrain is ranked 37th out of 173 countries with a rating of "high" and first in the Arab world. The economy of Bahrain is based on the petroleum industry, transit trade, and financial services. Services account for about two-third of GDP. Bahrain benefited from the region’s economic boom in the 1970 and 1980s. During that time, Bahrain’s government had encouraged economic diversification, it has focused on the development of its non-oil industry by investing heavily on industrial infrastructure and heavy industries. Due to diversification away from the oil sector, the contributions of the oil and gas sectors to GDP have declined from 25 per cent to around 18 per cent. The industrial development has grown in importance and currently the manufacturing sector provides about 12 per cent of GDP. Bahrain mainly produces Aluminum, which generates 40 per cent of the country’s non-oil export earnings, ship-building, and light goods such as furniture and fiberglass. Furthermore, tourism is Bahrain’s fastest growing industry, a major source of employment and contributes about 10 percent of GDP (HSBC, 2001). 10