Capital Adequacy Framework for Islamic

BanksDr. Habib Ahmed

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Lecture Plan Background Need for Bank Regulation Banking Regulatory Frameworks

Basel I (1988) Basel II (2006)

Regulatory Framework of Islamic Banks—IFSB Approach (2005)

Conclusion

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Background The banking industry is one of the

most regulated sectors Reasons of regulation:

One of most leveraged industries—protection against bankruptcy

Protect depositors/consumers Monetary, financial, and economic

stability (systemic risks)

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Background (2)

Basic balance sheet relationship:A=L+E

Or Net-worth=A-L=EIf –(Net-worth) E the firm is bankrupt

Assets Liabilities

AssetsDeposits/DebtCapital/Equity

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Role of CapitalExamples: Case 1: E=10State 0: A=100, L=90, E=10;State 1: A=95, L=90, E=5;State 2: A=85, L=90, E=-5; (Bankrupt)Case 2: E=20State 0: A=100, L=80, E=20;State 1: A=95, L=80, E=15;State 2: A=85, L=80, E=5

More risks need more capital (to avoid bankruptcy)

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Regulatory Capital Adequacy

Regulatory capital was initially identified by capital-ratio defined as:

Total Capital/Total Assets Imposing one capital ratio to all banks

was not prudent Some banks were engaged in riskier

activities than others Later Capital ratio evolved to

Total Capital/ Total Risk Assets

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Basel I Standards Basel Accord of 1988—standardized

bank capital requirements internationally

Types of regulatory bank capital Tier 1 Capital (core capital): common

stock, retained earnings, perpetual preferred stock, etc.

Tier 2 Capital (supplemental capital): Loan loss reserves, unpaid dividends, etc.

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Risk-Weighed Assets—Classification

Assets classified into 4 categories depending on credit risk Lowest risk category (no default risk)—0 risk

weight [e.g., Government bonds] 2nd Lowest risk category (low default risk)–20%

risk weight [e.g., interbank deposits, fully backed mortgage bonds, etc.]

3rd risk category (low to moderate default risk)—50% risk weight [e.g., municipal bonds, residential mortgages, etc.]

4th risk category (moderate to high default risk)—100% risk weight [e.g., all other loans, commercial papers, etc.]

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Basel I Capital Requirements

Capital Ratio Requirements: Ratio of total capital (Tier 1 &2) to risk weighted

assets must be at least 8 percent.

Capital Ratio=Total Capital/ Total Risk Assets=8%

Note: When an asset has a risk weight of 100%, the capital charge on it

is 8% When an asset has a risk weight of 50%, the capital charge on it

is 4%

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Capital Requirements—Example

Assets LiabilitiesCash 5,000Govt. Bonds 20,000Deposits at Banks 5,000Loans for Residential Properties 10,000Loans to Private Corporations 60, 000

Deposits/Debt 95,000Total Capital 5,000

Total 100,000

Total 100,000

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Capital Requirements—Example (contd…)

0% Risk WeightCashGovt. Bonds

5,00020,00025,000 x 0 = 0

20% Risk WeightBalances with Banks 5,000

5,000 x 0.2 = 1000

50% Risk WeightLoans for Residential Properties

10,00010,000 x 0.5 = 5000

100% Risk WeightLoans to Private Corporations60,000

60,000 x 1.0 = 60,000

Total Risk Weighted Assets66,000

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Capital Requirements—Example (contd…)

Total Assets =100,000 Total Risk Weighted Assets=66,000 Total Capital=5,000

Capital Ratio without risk weights Total Capital/Total

Assets=5,000/100,000=5% Capital Ratio with risk weights

Total Capital/Total Risk Weighted Assets=5,000/66,000=7.6%

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Capital Requirements—Example (contd…)

Two Banks A and B (with same assets and capital value)

Bank A (relatively more risky assets) Total Assets =100,000 Total Capital=5,000 Risk weighted Assets=75,000 Capital Ratio with risk weights

Total Capital/Total Risk Weighted Assets=5,000/75,000=6.7% Bank A (relatively less risky assets)

Total Assets =100,000 Total Capital=5,000 Risk weighted Assets=55,000 Capital Ratio with risk weights

Total Capital/Total Risk Weighted Assets=5,000/55,000=9.1%

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Capital Requirements—Example (contd…)

Regulatory Capital Requirements—8 % Bank A is undercapitalized (6.7%)—holding

less capital than required by regulation. It can increase its capital by:

Issuing new shares Reducing dividends (i.e., increasing retained earnings)

Reallocating assets (opt for less riskier assets) Bank B is overcapitalized (9.1%)– holding

more capital than regulatory capital It can reduce capital by:

Buying back shares Increasing dividends (i.e., decreasing retained

earnings). Reallocating assets (opt for more riskier assets)

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Basel I Capital Requirements—

Conclusions and Issues Regulatory Capital Requirements is 8%

of risk-based assets Composition of assets determines the

capital requirements Only Credit risk considered—does not

include market and operational risks Banks exposed to significant market

and operational risks (changes in interest rate, currencies, commodities, stock prices, etc.)

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Basel II Standards To fill in the gaps and to come up with an

appropriate regulatory capital requirements, Basel Committee on Banking Supervision initiated the Basel II standards in 1993

The standards were finally completed in June 2006

The Standards are complicated and complex (251 pages)

[http://www.bis.org/publ/bcbs107.htm]

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Basel II Standards—Main Features

A framework to further strengthen the soundness and stability of the international banking system

A more risk-sensitive capital requirements Three Pillars

Minimum Capital Requirements Supervisory Review Process Market Discipline

Minimum Capital Requirements—considers credit, market and operational risks

Not one, but different approaches to arrive at capital requirements

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Basel II Standards—Credit Risk

Credit Risk—Standardized Approach, Internal Ratings Based Approach, Securitization Framework

Credit Risk—different risk weights are given for various types of clients (Sovereign, public sector entities, MDBs, banks, securities firms, corporations, etc)

Example: Risk weights for corporations given below:

Credit Assessment

AAA to AA-

A+ to A-

BBB+ to BB-

Below BB-

Unrated

Risk Weight20%50%100%150%100%

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Basel II Standards—Market Risks

In conventional banking, Market risks arise mainly in the trading book (derivatives, securities, currency, commodities, etc.)

Held short-term to benefit from price movements

Different risk-weights given to various types of items (derivatives, debt securities, etc.)

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Basel II Standards—Operational Risks

Operational Risk—three approaches Basic Indicator Approach Standardized Approach Advanced Measurement Approach

Basic Indicator Approach:K=GI x α

K-capital charge (for operational risk)GI-average gross income over last 3 years α – 15 %

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Lecture Plan Background Need for Bank Regulation Banking Regulatory Frameworks

Basel I (1988) Basel II (2006)

Regulatory Framework of Islamic Banks—IFSB Approach (2005)

Conclusion

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IFSB Standards—Introduction

In December 2005 IFSB published “CAPITAL ADEQUACY STANDARD FOR INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES” (71 pages)

http://www.ifsb.org/ Uses the following BCBS documents to

arrive at capital requirements: International Convergence of Capital

Measurement and Capital Standards: A Revised Framework, June 2004 (BASEL II 2004)

Amendment to Capital Accord to Incorporate Market Risks, January 1996—for Market Risks (Market Risks 1996)

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Typical IB Model Liability side

Profit Sharing Investment Accounts (PSIA)- mudarabah

Demand deposits-qard hasan Profit-Equalizing Reserves

(PER) Investment Risk Reserves

(IRR)

Asset side Fixed income assets

(murabahah, istisna, salam, and ijarah)

Variable income assets (mudarabah and musharakah)

Balance Sheet

Assets Liabilities

Banking Portfolio

Deposits & Debt

Trading Portfolio

ReservesEquity

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Issues in Capital Adequacy for IBs

Asset side: Islamic Instruments have both credit and

market risks and the risks change according to the stage of the contract

Identify the credit/market risks in the instruments and assign the appropriate risk weights (from Basel II standards)

Liability side: Role of PSIA

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IFSB Capital Adequacy Standards—Basic Elements

Credit Risk: Standardized Approach (BASEL II 2004)

Operational Risk: Basic Indicator Approach (BASEL II 2004)

Market Risk: Applications from Market Risk 1996.

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Capital Requirements— Example (1): Salam

contract Applicable Stage of the Contract

Credit RWMarket Risk Capital Charge

Payment of Purchase Price by the IIFS to a Salam customer

Based on customer’s rating or 100% RW for unrated customer

The Simplified Approach15% capital charge on long position of salam exposures

Receipt of the purchased commodity by the IIFS

Not Applicable

The purchased commodity is sold and delivered to a buyer

Not ApplicableNot Applicable

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Capital Requirements— Example (2): Operating Ijarah

Applicable Stage of the Contract

Credit RWMarket Risk Capital Charge

Asset available for lease (prior to signing a lease contract

Binding Promise to Ijarah (PL)Asset Acquisition cost less (a) market value of asset fulfilling function of collateral and (b) hamish jiddiyahMultiply with the customer’s rating or 100% RW for unrated customer

Non-binding PL15% capital charge until lessee takes possession

Upon consigning a leasing contract and the lease rental payments are due from the lessee

Total estimate value of the lease receivables shall be risk-weighted according to the lessee’s rating. 100% RW for unrated customer

The residual value will be risk-weighted 100%

Maturity of the contract term and the leased asset is returned to IIFS

Not applicable15% capital charge of the carrying value of the asset

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IFSB Standards Standard formula for regulatory capital

Eligible capital/[Total risk-weighted assets (credit and market risks) + Operational Risk – Risk-weighted assets funded by PSIA (credit and market risks)]

Note: Islamic Financial Instruments are more riskier—

increases capital requirements PSIA are profit/loss sharing contracts—can

share the losses—substitutes for capital (reduces capital requirements)

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IFSB Standards-Example (1)

Assume Total risk weighted assets=120% of total assets= 108 Average Gross Income of last 3 years = 10 Operational Risk Capital base = 10 x 0.15=1.5 Percentage Total Assets financed by PSIA=40/90=44.4% Risk weighted assets financed by PSIA= .444 x 108=48

Standard formula for regulatory capital Eligible capital/[Total risk-weighted assets (credit and

market risks) + Operational Risk – Risk-weighted assets funded by PSIA (credit and market risks)]

= 5/[108+1.5-48] = 5/61.5 = 8.1%

AssetsLiabilitiesCash 10Total Assets 90

PSIA 40Demand Deposits 55Equity 5

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IFSB Standards-Example (2)

Assume Total risk weighted=120% of total assets= 108 Average Gross Income of last 3 years = 10 Operational Risk Capital base = 10 x 0.15=1.5 Percentage Total Assets financed by PSIA=20/90=22.2% Risk weighted assets financed by PSIA= 0.222 x 108=24

Standard formula for regulatory capital Eligible capital/[Total risk-weighted assets (credit and

market risks) + Operational Risk – Risk-weighted assets funded by PSIA (credit and market risks)]

=5/[108+1.5-24]=5/85.5= 5.9%

AssetsLiabilitiesCash 10Total Assets 90

PSIA 20Demand Deposits 75Equity 5

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Conclusion The nature of risks in IFIs complex—

requires different regulatory standards Assets of IBs more riskier that

conventional banks Composition of both assets and liabilities

(deposits) determine the capital requirements

By sharing the risks, PSIA offsets the capital requirements of IBs riskier assets

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Thank you!