Capital Adequacy Framework for Islamic Banks

Dr. Habib Ahmed

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 2

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) 3

Background (2)

Assets

Assets Liabilities

Deposits/Debt Capital/Equity Basic balance sheet relationship: A=L+E Or Net-worth=A-L=E If –(Net-worth)  E the firm is bankrupt 4

Role of Capital

Examples:

Case 1: E=10 State 0:

State 1:

A=100,

A=95, State 2: A=85,

Case 2: E=20 State 0:

State 1: State 2:

A=100,

A=95, A=85,

L=90, E=10;

L=90, E=5; L=90, E=-5; (Bankrupt)

L=80, E=20;

L=80, E=15; 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 6

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]  2 nd Lowest risk category (low default risk)–20% risk weight [e.g., interbank deposits, fully backed mortgage bonds, etc.]   3 rd risk category (low to moderate default risk)—50% risk weight [e.g., municipal bonds, residential mortgages, etc.] 4 th risk category (moderate to high default risk)—100% risk weight [e.g., all other loans, commercial papers, etc.] 8

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% 9

Capital Requirements— Example

Assets

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

Total 100,000 Liabilities

Deposits/Debt 95,000 Total Capital 5,000

Total 100,000

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Capital Requirements— Example (contd…)

0% Risk Weight

Cash Govt. Bonds 5,000 20,000 25,000 x 0 = 0

20% Risk Weight

Balances with Banks 5,000 5,000 x 0.2 = 1000

50% Risk Weight

Loans for Residential Properties 10,000 10,000 x 0.5 = 5000

100% Risk Weight

Loans to Private Corporations

Total Risk Weighted Assets

60,000 60,000 x 1.0 = 60,000

66,000

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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% 12

  

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% 13

  

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) 14

   

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.) 15

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] 16

    

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 17

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 Risk Weight AAA to AA 20% A+ to A 50% BBB+ to BB 100% Below BB 150% Unrated 100% 18

  

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.) 19

 

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 % 20

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 21

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) 22

Balance Sheet Assets

Banking Portfolio Trading Portfolio

Typical IB Model

Liabilities

Deposits & Debt Reserves Equity   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) 23

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 24

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 RW Market 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 Approach 15% 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 Applicable Not Applicable 26

Capital Requirements— Example (2): Operating Ijarah

Applicable Stage of the Contract Credit RW Market Risk Capital Charge

Asset available for lease (prior to signing a lease contract Upon consigning a leasing contract and the lease rental payments are due from the lessee Maturity of the contract term and the leased asset is returned to IIFS Binding Promise to Ijarah (PL) Asset Acquisition cost less (a) market value of asset fulfilling function of collateral and (b) hamish

jiddiyah

Multiply with the customer’s rating or 100% RW for unrated customer Total estimate value of the lease receivables shall be risk-weighted according to the lessee’s rating. 100% RW for unrated customer Not applicable Non-binding PL 15% capital charge until lessee takes possession The residual value will be

risk-weighted 100%

15% capital charge of the carrying value of the asset 27

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) 28

IFSB Standards-Example (1)

Cash 10 Total Assets 90  

Assets Liabilities

PSIA 40 Demand Deposits 55 Equity 5 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% 29

IFSB Standards-Example (2)

Cash 10 Total Assets 90  

Assets Liabilities

PSIA 20 Demand Deposits 75 Equity 5 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% 30

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 31

Thank you!

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