capital adequacy in islamic banks

8/6/2019 Capital Adequacy in Islamic Banks

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Capital Adequacy Framework for Islamic

BanksDr. Habib Ahmed


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Lecture PlanBackgroundNeed for Bank Regulation

Banking Regulatory FrameworksBasel I (1988)Basel II (2006)

Regulatory Framework of Islamic BanksIFS B Approach (2005)Conclusion


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BackgroundThe banking industry is one of the mostregulated sectorsReasons of regulation:

One of most leveraged industriesprotectionagainst bankruptcy Protect depositors/consumers

Monetary, financial, and economic stability (systemic risks)


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Background (2)

Basic balance sheet relationship:

A=L+EOr Net-worth=A- L=EIf (Net-worth) E the firm is b ankrupt

Lia b ilities Assets

Deposits/DebtCapital/ Eq uity

Assets


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Role of CapitalEx amples: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 b ankruptcy)


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Regulatory Capital Ade quacy Regulatory capital was initially identified by capital-ratio defined as:

Total Capital/ Total AssetsImposing one capital ratio to all banks wasnot prudentSome banks were engaged in riskier

activities than othersLater Capital ratio evolved toTotal Capital/ Total Risk Assets


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Basel I StandardsBasel Accord of 1988standardized bank capital re quirements internationally T ypes of regulatory bank capital

Tier 1 Capital (core capital): common stock,retained earnings, perpetual preferred stock,etc.

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


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Risk-Weighed Assets

Classification Assets classified into 4 categories depending oncredit risk Lowest risk category (no default risk) 0 risk weight [e.g., Government bonds]

2nd

Lowest risk category (low default risk) 20% riskweight [e.g., interbank deposits, fully backed mortgage bonds, etc.]3rd risk category (low to moderate default risk) 5 0%risk weight [e.g., municipal bonds, residentialmortgages, etc.]4 th 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 Re quirementsCapital Ratio Re quirements:

Ratio of total capital ( Tier 1 &2) to risk weighted assetsmust be at least 8 percent.

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

N ote:

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 Re quirements

Ex ampleLia b ilities Assets

Deposits/Debt 95,000

Total Capital 5,000

Cash 5,000

Govt. Bonds 20,000Deposits at Banks 5,000Loans for ResidentialProperties 10,000

Loans to PrivateCorporations 60, 000

Total 100,000Total 100,000


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Ex ample (contd)5,000

20,00025,000 x 0 = 0

0% Risk WeightCashGovt. Bonds

5,0005,000 x 0.2 = 1000

20% Risk WeightBalances with Banks

10,00010,000 x 0.5 = 5000

5 0% Risk WeightLoans for Residential Properties

60,00060,000 x 1.0 = 60,000

100% Risk WeightLoans to Private Corporations

66,000To tal Risk Weighted Assets


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Capital Re quirements Ex ample

(contd)Total Assets =100,000Total Risk Weighted Assets=66,000Total Capital=5,000

Capital Ratio without risk weightsTotal Capital/ Total Assets=5,000/100,000=5%

Capital Ratio with risk weightsTotal Capital/ Total Risk Weighted

Assets=5,000/66,000=7.6%


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(contd)T wo Banks A and B (with same assets and capital value)Bank A (relatively more risky assets)

Total Assets =100,000Total Capital=5,000

Risk weighted Assets=75,000Capital 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=5,000Risk weighted Assets=55,000Capital Ratio with risk weights

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


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(contd)Regulatory Capital Re quirements8 %Bank A is undercapitalized (6.7%)holding lesscapital than re quired by regulation.

It can increase its capital by:Issuing new sharesReducing dividends (i.e., increasing retained earnings)Reallocating assets (opt for less riskier assets)

Bank B is overcapitalized (9.1%) holding morecapital than regulatory capital

It can reduce capital by:Buying back sharesIncreasing dividends (i.e., decreasing retained earnings).Reallocating assets (opt for more riskier assets)


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Basel I Capital RequirementsConclusions and Issues

Regulatory Capital Re quirements is 8% of risk-based assetsComposition of assets determines thecapital re quirementsOnly Credit risk considereddoes notinclude market and operational risks

Banks e xposed to significant market andoperational risks (changes in interest rate,currencies, commodities, stock prices, etc.)


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Basel II StandardsTo fill in the gaps and to come up with anappropriate regulatory capital re quirements, BaselCommittee on Banking Supervision initiated the

Basel II standards in 1993The standards were finally completed in June2006The Standards are complicated and comple x (251pages)

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


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Basel II StandardsMainFeatures

A framework to further strengthen the soundnessand stability of the international banking system

A more risk-sensitive capital re quirements

Three PillarsMinimum Capital Re quirementsSupervisory Review ProcessMarket Discipline

Minimum Capital Re quirementsconsiderscredit, market and operational risksNot one, but different approaches to arrive atcapital re quirements


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Basel II Standards

Credit Risk Credit RiskStandardized Approach, Internal RatingsBased Approach, Securitization Framework Credit Riskdifferent risk weights are given for varioustypes of clients (Sovereign, public sector entities, MD Bs,

banks, securities firms, corporations, etc)Ex ample: Risk weights for corporations given below:

UnratedBelow BB-

BBB+ toBB-

A + to A- AAA to AA-

Credit Assessment

100%150%100%50%20%Risk Weight


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Basel II StandardsMarket Risks

In conventional banking, Market risks arisemainly in the trading book (derivatives,securities, currency, commodities, etc.)Held short-term to benefit from pricemovementsDifferent risk-weights given to various typesof items (derivatives, debt securities, etc.)


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Basel II StandardsOperational Risks

Operational Riskthree approachesBasic Indicator ApproachStandardized Approach

Advanced Measurement Approach

Basic Indicator Approach:K=GI xK-capital charge (for operational risk)GI-average gross income over last 3 years

15 %


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Lecture PlanBackgroundNeed for Bank Regulation

Banking Regulatory FrameworksBasel I (1988)Basel II (2006)

Regulatory Framework of IslamicBanksIFSB Approach (200 5 )Conclusion


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IFS B StandardsIntroductionIn December 2005 IFS B publishedCAPI T A L ADEQ UACY ST ANDARD FOR INS TITUTIONS OFF ERING ON L Y ISL AMICFINANCIA L SERVIC ES (71 pages)

http://www.ifs b .org/Uses the following BCBS documents to arrive atcapital re quirements:

International Convergence of Capital Measurement and

Capital Standards: A Revised Framework, June 2004(B ASEL II 2004) Amendment to Capital Accord to Incorporate MarketRisks, January 1996for Market Risks (Market Risks1996)


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Issues in Capital Ade quacy for I Bs

Asset side:Islamic Instruments have both credit andmarket risks and the risks change according to

the stage of the contractIdentify the credit/market risks in theinstruments and assign the appropriate risk

weights (from Basel II standards)

Liability side: Role of PSIA


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IFS B Capital Ade quacy Standards Basic E lements

Credit Risk: Standardized Approach(B ASEL II 2004)

Operational Risk: Basic Indicator Approach(B ASEL II 2004)

Market Risk: Applications from Market Risk 1996.


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Ex ample (1): S alam contractMarket Risk CapitalCharge

Credit RW Applica b le Stage of the Contract

The Simplified Approach15 % capital charge on longposition of salam exposures

Based on customers ratingor 100% RW for unratedcustomer

Payment of Purchase Price by the IIFS to a Salamcustomer

Not ApplicableReceipt of the purchasedcommodity by the IIFS

Not ApplicableNot ApplicableThe purchased commodity issold and delivered to a buyer


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Capital Re quirements Ex ample(2): Operating I jarah

Market Risk Capital Charge

Credit RW Applica b le Stageof the Contract

Non-binding P L15 % capital charge untillessee takes possession

Binding Promise to I jarah (P L) Asset Ac quisition cost

less (a) market value of asset fulfillingfunction of collateral and (b) hamish

jiddiyahMultiply with the customers rating or100% RW for unrated customer

Asset available for lease(prior to signing a leasecontract

The residual value will berisk-weighted 100%

Total estimate value of the leasereceivables shall be risk-weightedaccording to the lessees rating. 100%RW for unrated customer

Upon consigning aleasing contract and thelease rental payments aredue from the lessee

15 % capital charge of thecarrying value of the asset

Not applicableMaturity of the contractterm and the leased assetis returned to IIFS


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IFS B StandardsStandard formula for regulatory capital

E ligible capital/ [Total risk-weighted assets (credit andmarket risks) + Operational Risk Risk-weighted assetsfunded by PSIA (credit and market risks)]

Note:Islamic Financial Instruments are more riskierincreases capital re quirements

PSIA are profit/loss sharing contractscan share thelossessubstitutes for capital (reduces capitalre quirements)


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IFS B Standards- Ex ample (1)

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

Standard formula for regulatory capitalE ligible capital/ [Total risk-weighted assets (credit and market risks)

+ Operational Risk Risk-weighted assets funded by PSIA (creditand market risks)]

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

Lia b ilities AssetsPSIA 40Demand Deposits 55Eq uity 5

Cash 10Total Assets 90


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IFS B Standards- Ex ample (2)

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

Standard formula for regulatory capitalE ligible capital/ [Total risk-weighted assets (credit and market risks)

+ Operational Risk Risk-weighted assets funded by PSIA (creditand market risks)]

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

Lia b ilities AssetsPSIA 20Demand Deposits 75Eq uity 5

Cash 10Total Assets 90


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Conclusion

The nature of risks in IFIs comple xre quires different regulatory standards Assets of I Bs more riskier that conventional

banksComposition of both assets and liabilities(deposits) determine the capitalre quirementsB y sharing the risks, PSIA offsets thecapital re quirements of I Bs riskier assets


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Thank you!

capital adequacy in islamic banks

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