Capital Adequacy Framework for Islamic Banks

1. Capital Adequacy Framework for Islamic Banks Dr. Habib Ahmed

2. 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

3. 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)

4. Background (2) Basic balance sheet relationship: A=L+E Or Net-worth=A-L=E If –(Net-worth)  E the firm is bankrupt

5. Role of Capital Examples: Case 1: E=10 State 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=20 State 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)

6. 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

7. 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.

8. Risk-Weighed Assets—Classification • Assets classified into 4 categories depending on credit risk • Lowest risk category (no default risk)—0risk 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.]

9. 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%

10. Capital Requirements—Example

11. Capital Requirements—Example (contd…)

12. 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%

13. 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%

14. 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)

15. 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.)

16. 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]

17. 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

18. 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:

19. 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.)

20. 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 %

21. 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

22. 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)

23. Typical IB Model • Liability side • Profit Sharing Investment Accounts (PSIA)- mudarabah • Demand deposits-qardhasan • Profit-Equalizing Reserves (PER) • Investment Risk Reserves (IRR) • Asset side • Fixed income assets (murabahah, istisna, salam, and ijarah) • Variable income assets (mudarabah and musharakah)

24. 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

25. 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.

26. Capital Requirements— Example (1): Salam contract

27. Capital Requirements— Example (2): Operating Ijarah

28. 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)

29. 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%

30. 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%

31. 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

32. Thank you!