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Capital Adequacy Framework for Islamic Banks Dr. Habib Ahmed.

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Presentation on theme: "Capital Adequacy Framework for Islamic Banks Dr. Habib Ahmed."— Presentation transcript:

1 Capital Adequacy Framework for Islamic Banks Dr. Habib Ahmed

2 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 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 4 Background (2) Basic balance sheet relationship: A=L+E OrNet-worth=A-L=E If –(Net-worth)  E the firm is bankrupt LiabilitiesAssets Deposits/Debt Capital/Equity Assets

5 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 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 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 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]  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.]

9 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 10 Capital Requirements— Example LiabilitiesAssets Deposits/Debt 95,000 Total Capital 5,000 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

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

12 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 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 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 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 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 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 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: UnratedBelow BB- BBB+ to BB- A+ to A-AAA to AA- Credit Assessment 100%150%100%50%20%Risk Weight

19 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 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 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 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 23 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 LiabilitiesAssets Deposits & Debt Banking Portfolio Reserves Equity Trading Portfolio

24 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 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 26 Capital Requirements— Example (1): Salam contract Market Risk Capital Charge Credit RWApplicable 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 ApplicableReceipt of the purchased commodity by the IIFS Not Applicable The purchased commodity is sold and delivered to a buyer

27 27 Capital Requirements— Example (2): Operating Ijarah Market Risk Capital Charge Credit RWApplicable 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 applicableMaturity of the contract term and the leased asset is returned to IIFS

28 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 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/[ ] = 5/61.5 = 8.1% LiabilitiesAssets PSIA 40 Demand Deposits 55 Equity 5 Cash 10 Total Assets 90

30 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= 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% LiabilitiesAssets PSIA 20 Demand Deposits 75 Equity 5 Cash 10 Total Assets 90

31 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 32 Thank you!


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