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Capital Adequacy Framework for Islamic Banks

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Presentation on theme: "Capital Adequacy Framework for Islamic Banks"— Presentation transcript:

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) Liabilities Assets 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

5 More risks need more capital (to avoid bankruptcy)
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)—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.]

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
Liabilities Assets Deposits/Debt ,000 Total Capital ,000 Cash ,000 Govt. Bonds ,000 Deposits at Banks ,000 Loans for Residential Properties ,000 Loans to Private Corporations , 000 Total ,000

11 Capital Requirements—Example (contd…)
5,000 20,000 25,000 x 0 = 0 0% Risk Weight Cash Govt. Bonds 5,000 x 0.2 = 1000 20% Risk Weight Balances with Banks 10,000 10,000 x 0.5 = 5000 50% Risk Weight Loans for Residential Properties 60,000 60,000 x 1.0 = 60,000 100% Risk Weight Loans to Private Corporations 66,000 Total Risk Weighted Assets

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) Risk weighted Assets=55,000 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: Unrated Below BB- BBB+ to BB- A+ to A- AAA to AA- Credit Assessment 100% 150% 50% 20% Risk Weight

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) 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 Asset side Balance Sheet Liabilities
Deposits & Debt Banking Portfolio Reserves Equity Trading Portfolio 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)

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
Market Risk Capital Charge Credit RW Applicable Stage of the Contract The Simplified Approach 15% capital charge on long position of salam exposures Based on customer’s rating or 100% RW for unrated customer Payment of Purchase Price by the IIFS to a Salam customer Not Applicable Receipt of the purchased commodity by the IIFS The purchased commodity is sold and delivered to a buyer

27 Capital Requirements— Example (2): Operating Ijarah
Market Risk Capital Charge Credit RW Applicable Stage of the Contract Non-binding PL 15% capital charge until lessee takes possession 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 Asset available for lease (prior to signing a lease contract The residual value will be risk-weighted 100% Total estimate value of the lease receivables shall be risk-weighted according to the lessee’s rating. 100% RW for unrated customer Upon consigning a leasing contract and the lease rental payments are due from the lessee 15% capital charge of the carrying value of the asset Not applicable Maturity of the contract term and the leased asset is returned to IIFS

28 IFSB Standards Standard formula for regulatory capital Note:
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)
Liabilities Assets PSIA Demand Deposits Equity Cash Total Assets 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/[ ] = 5/61.5 = 8.1%

30 IFSB Standards-Example (2)
Liabilities Assets PSIA Demand Deposits Equity Cash Total Assets 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= 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/[ ]=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!


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