1. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 0 Workshops on Facilitating the Implementation of IFSB Standards CAPITAL ADEQUACY STANDARD FOR Institutions ( Other than Insurance Institutions) Offering only Islamic Financial Services Cairo, Egypt 27 – 28 August 2008 All rights reserved. No part of this publication may be reproduced, translated, stored in or introduced into a retrieval system or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the Islamic Financial Services Board.

2. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 1 Case Study Measurement of Capital Adequacy Ratios of an IIFS

3. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 2 Learning Objectives Participants will be able to:  Understand the background for and context of the IFSB-CAS  Identify and classify the risks associated with Shari’ah compliant instruments  Define data requirements for: o the key calculations for the relevant approaches and; o the main exposure types  Execute the basic calculations for the capital adequacy formulas

4. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 3 Methodology Capital adequacy ratios using IFSB and Basel II are calculated based on: Type of RiskBasel approach Credit RiskStandardised Approach Market Risk 1996 Market Risk Amendments (Standardised Measurement Method) Operational RiskBasic Indicator Approach

5. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 4 Assumptions Credit Risk 1.All International Murabahah and Wakalah attract a RW of 50%, as they represent transactions with high credit quality rated international banks with residual maturity up to 3 months 2.Murabahah and Ijarah (in local currency) treated under preferential risk weights  50% of Murabahah & Ijarah are for retail business; and  50% of Murabahah & Ijarah are over collectivized by RRE 3.Investment in Government Musharakah Sukuk are treated as Sukuk held in the banking book 4.No past due receivable

6. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 5 Assumptions cont’d Market Risk 5.For inventories, book values = market values of the commodities at spot market prices 6.Residual value of assets leased = amount receivable from operating Ijarah less 10% depreciation Sources of Funds 7.Percentage of assets funded by unrestricted PSIA is 27%

7. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 6 Balance Sheet To Identify risks associated with Shari’ah compliant products To classify risks

8. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 7 Assets Cash & cash equivalent (local)7,640,300,010.54 Cash & cash equivalents (foreign)3,666,429,588.06 Correspondents A/Cs5,319,257,257.77 Account Receivables International Murabahah (foreign)47,395,740,416.74 Wakalah (foreign)13,232,002,133.74 Murabahah (local)21,198,540,883.65 Istisnaa7,190,999.45 Ijarah2,589,290,037.89 Qard839,980,349.77 Diminishing Musharakah2,297,075,300.36 Mudarabah147,785,420.15 Properties held for sale179,733,023.67 Investments Investment in Govt. Musharakah Sukuk18,257,778,137.78 Investment in equities (subsidiaries)1,804,968,610.01 Other assets2,956,549,000.00 Fixed Assets4,742,207,616.78 Total On-balance sheet items132,477,828,786.36 Off/balance sheet items30,573,255,130.56 Total assets163,051,083,916.92 Liabilities Current Accounts (local)33,095,265,730.85 Current Accounts (Foreign)51,134,349,148.22 Other A/Cs (foreign)492,485,700.62 other A/Cs (local)33,492,930.20 Sub-total84,755,593,509.89 Unrestricted investment accounts (local)26,040,775,217.25 Unrestricted investment accounts (foreign)9,374,904,225.32 Sub-total35,415,679,442.57 Other liabilities4,462,923,826.89 Owner equities7,843,632,007.01 Total on-balance sheet items132,477,828,786.36 Contingent liabilities Acceptance Commitments7,435,832,969.93 L/Gs commitments1,645,478,824.17 L/Cs Commitments10,891,835,984.49 Other commitments10,600,107,351.97 Total Liabilities163051083916.92

9. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 8 Basel I Calculation of capital adequacy ratio:  A brief reminder

10. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 9 IFSB-CAS Calculation of Capital Requirements for Credit Risk

11. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 10 RefCategoryExposureRWACAR Capital Requirements for Credit Risk Form C2RWA for individual claims based on ECA00.008%0.00 Form C 3RWA for short-term exposures & other assets 71,618,530.0042,452,896.50 8%3,396,231.72 Form C 4RWA for exposures under profit sharing mode18,257,778.000.008%0.00 Form C 5RWA for exposures with preferential risk weights23,787,830.0013,083,306.508%1,046,664.52 Form C 6RWA for past due receivables0.00 8%0.00 Form C 7RWA for Off-balance sheet exposures30,573,255.0020,057,015.748%1,604,561.25 Total144,237,393.0075,593,218.74 6,047,457.50 Calculation of Capital Requirements for Credit Risk FORM C1: Summary Table for Credit Risk Capital Requirements

12. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 11 Exposure TypeRatingRW Original Exposure Credit Risk Mitigation Techniques RWA Supervisory Haircut Simple Approach Amount of collateral Haircut % Adjusted Collateral Net Exposure RW of counterparty 123 4567 8 9 4 ( 1 - 5 )( 3 - 6 ) (3 x 2) or (7 x 2) or (3 x 8) Short-term Exposure A-1/P-120% International Murabahah & Wakalah* A-2/P-250% 60,627,742.00 30,313,871.00 A-3/P-3100% Diminishing Musharakahothers150%2,297,075.00 3,445,312.50 MudarabahUnrated100%147,785.00 IstisnaUnrated100%7,191.00 QardUnrated100%839,980.00 Other assets 100%2,956,549.00 Fixed Assets 100%4,742,208.00 Total Exposure 71,618,530.00 42,452,896.50 FORM C3: RWA for Short-term Exposure and Other Assets Calculation of Capital Requirements for Credit Risk Refer to slide (5) - assumptions

13. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 12 Exposure TypeRatingRWOriginal Exposure CRM RW Simple Approach RW of counterparty 1 2 3 4 5 (3x2) or (3x4) MudarabahSimple Method 300% Govt. Musharakah Sukuk 400%18,257,778.00 0%*0 Joint Ownership of real estate and movable assetsSlotting method 90% 100% 135% 270% Total 18,257,778.00 0 Calculation of Capital Requirements for Credit Risk FORM C 4: RWA for Investments made under Profit sharing Mode * Assuming RW of Govt. is zero

14. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 13 AExposure TypeRW Amount of Exposure Value of Collateral ** Haircut % *** Value of eligible collateral Net Exposure RWA 1234567 3 ( 1 - 4)(2 - 5) (2 x 1 ) or (6 x 1) 1 Murabahah or Ijarah collateralized by residential real estate 35% 11,893,915.00 4,162,870.25 2 Murabahah or Ijarah collateralized by Commercial real estate 50% 100% 3 Murabahah and/or Ijarah receivables from individuals or small business (retail) 75% 11,893,915.00 8,920,436,25 Total 23,787,830.00 13,083,306.50 * Preferential Risk Weights if the underlying assets are sold under Murabahah or leased under Ijarah ** collaterals other than real estate such as Hamish jiddiah or Urbon *** Cash collateral in foreign currencies subject to a haircut of 8% Calculation of Capital Requirements for Credit Risk FORM C 5: RWA for Exposures with Preferential Risk Weights*

15. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 14 Calculation of Capital Requirements for Credit Risk FORM C 7: Off-balance Sheets Exposures ExposureCCFOutstanding Amount Credit Equivalent Adjusted collateral Net ExposureRWRWA 123 ( 1 x 2) 45 ( 3 – 4) 67 (5 x 6) L/Cs collateralized by underlying shipments / goods 20%10,891,8362,178,367450,6771,727,690100%1,727,690 ≤ 1 year commitments20%1,645,479329,09535,710293,385100%293,385 ≥ 1 year commitments50% others100%18,035,940 0 100%18,035,940 Total30,573,25520,543,402486,38720,057,015

16. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 15 Calculation of Capital Requirements for Market RiskMarket Risk IFSB-CAS

17. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 16 Ref. Exposure Capital RequirementsCF*RWA Form D2Total Equity Risk Capital Charge 0 0 12.5 0 Form D3Total Specific Risk Capital Charge for Sukuk positions0 12.5 Form D4 Total General Risk Capital Charge for Sukuk and off- balance sheet financial instruments 12.5 Form D5Total foreign exchange capital charge**271,804.8012.53,397,560.00 Form D6Total commodity risk capital charge 12.50 Form D7Total inventory risk capital charge 2,776,214.00 213,504.0012.52,668,800.00 Total 485,308.8012.56,066,360.00 * reciprocal of minimum capital adequacy ratio ** This balance can be checked from the position in foreign currency Calculation of Capital Requirements for Market Risk FORM D 1: Summary of Market Risk Capital Requirements

18. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 17 Currency Net Spot Position 1 Net Forward Position 2 Guarantees 3 Other Items 4 Net Long PositionorNet Short Position US dollar (-)27,891.74 27,891.7 0.0 Saudi Riyal (+)3,357,303.91 3,357,303.9 Jordanian Dinar 0.0 Qatar Riyal (-)77.63 77.6 0.0 Sterling P (+)40,257.30 40,257.3 Euro (-)867,583.83 867,583.8 0.0 UAE Dirham (-)372.16 372.2 0.0 Oman Riyal (-)23.41 23.4 0.0 Bahrai Dinar (-)22.41 22.4 0.0 Total Position 895,971.2 3,397,561.2 XY Net Gold Position Z Capital charge calculation Greater of Net Long Position (X) or absolute value of Net Short Position (Y) Absolute value Net Gold or Silver Position (Z) Capital RequirementTotal Capital Charge 3,397,561.20.08%271,804.80 Calculation of Capital Requirements for Market Risk FORM D 5: Foreign Exchange Risk Capital Charges

19. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 18 Book Value Market ValueCapital Charge Capital requirement Properties held for sale 179,733.00 15%26,960.00 Salam (without parallel Salam) 15% Unbilled WIP inventory under Istisna without parallel Istisna 7,191.00 1.6%115.10 Residual value of assets leased*2,589,290.00 2,330,361.00* 8%186,428.90 Total 2,776,214.002,517,285.00 213,504.00 Calculation of Capital Requirements for Market Risk FORM D 7: Inventory Risk Capital Charges *Assuming 10% depreciation, See slide (6) - Assumptions

20. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 19 Calculation of Capital Requirements for Operational Risk IFSB-CAS

21. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 20 200420052,006 Net income from financing activities1,459,0002,582,000.004,903,000.00 Net income from investment activities22,000.0068,000.0076,000.00 Fee income (e.g. commission and agency fee)578,0001,413,0002,547,000 2,059,000.004,063,000.007,526,000.013,648,000 Less Investment account holders' share of income340,000.00715,000.001,632,0002,687,000 Gross income1,719,000.003,348,000.005,894,00010,961,000 Average Gross Income3,653,666.67 Assigned Capital Charge15% Capital requirement for operational risk548,050.00 Conversion factor12.5 Operational Risk Weighted Assets6,850,625 Calculation of Capital Requirements for Market Risk FORM E: Operational Risk

22. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 21 Calculation of Eligible Capital IFSB-CAS

23. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 22 Tier 1 CapitalAmountTier 2 CapitalAmount Issued and fully paid ordinary shares/common stock7,000,000Asset revaluation reserve275,025611,167 Perpetual non-cumulative preference shares General provisions Share premium Hybrid capital instruments Legal reserves240,705 Subordinated debt of more than 5 years Retained profit Less: Goodwill TOTAL7,240,705275,025 Tier 1 + Tier 2 = 7,515,730 Less : Investment in subsidiaries = 1,804,969 Total Eligible capital = 5,710,762 Calculation of Eligible Capital FORM F: Eligible Capital Ratio of Tier 2 to Tier 1 = 3.8%

24. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 23 Calculation of CA ratios Comparison:  IFSB formula  Basel II formula  Basel I formula

25. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 24 IFSB FormulaBasel II formulaBasel I Formula a) Total eligible regulatory capital which is used as the numerator for CAR5,710,762.00 b) Total RWA for credit risk75,593,218.74 32,513,792.00 c) Total RWA for market risk6,066,360.00 d) Sub-total81,659,578.74 38,580,152.00 e) Total RWA for operational risk6,850,625.008,530,000.00 Total RWA88,510,203.7490,189,578.7438,580,152.00 f) RWA (CR & MR) funded by profit sharing investment account holders22,048,086.26 RWA (CR & MR) funded by restricted investment account holders00 RWA (CR & MR) funded by unrestricted investment account holders 27% 22,048,086.26 RWA (CR & MR) funded by PER and IRR g) Minimum Capital Adequacy Requirements h) Total RWA - RWA funded by unrestricted PSIA( CR + MR) ( e – f) 66,462,117.48 o) Standard Formula 8.6% 6.3%14.8% p) Supervisory Formula Calculation of Capital Adequacy Ratios

26. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 25 Group Exercise 4 Analyses: The Impact of Balance Sheet Structure on Capital Adequacy Ratio

27. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 26 Balance sheet Structure of Hypothetical Banks Assets Liabilities Other Mudarabah Musharakah Istisna Ijarah Murabahah Large PSIA portfolio Significant Musharakah and Mudarabah exposure Source: Modified from McKinsey Bank A Other CA + SA PSIA Equity

28. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 27 Balance sheet Structure of Hypothetical Banks cont’d AssetsLiabilities Limited PSIA within deposit base Limited Musharakah and Mudarabah exposure Source: Modified from McKinsey Bank B Other Mudarabah Musharakah Istisna Ijarah Mudarabah Other CA + SA PSIA Equity

29. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 28 Other CA + SA PSIA Equity Other Mudarabah Musharakah Istisna Ijarah Murabahah Limited PSIA within deposit base Significant Musharakah and Mudarabah exposure Source: Modified from McKinsey Balance sheet Structure of Hypothetical Banks cont’d Bank C LiabilitiesAssets

30. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 29 Thank you …

31. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 30 Mashair Mohammed Ibrahim Assistant Project Manager Islamic Financial Services Board 3rd Floor Block A, Bank Negara Malaysia Building Jalan Dato’ Onn, 50480 Kuala Lumpur, Malaysia P.O.Box 10591, 50714 Kuala Lumpur, Malaysia Telephone: 603 – 26984248 ext. 135 Fax: 603-26984280 e-mail: mashair@ifsb.orgmashair@ifsb.org Contact information

32. FACILITATING THE IMPLEMENTATION OF IFSB STANDARDS FIS WORKSHOP SERIES © ISLAMIC FINANCIAL SERVICES BOARD 31 Summary of Capital Requirements for Shari’ah Compliant Contracts Contract Risk weights Credit Risk**Market RiskCR + MR Murabahah  Inventory  Asset delivered to a counterparty N.A. 100% 187.5% N.A. 187.5% 100% Salam  Salam without parallel Salam  Salam with Parallel Salam 100% 187.5% 287.5 % + 24% 287.5% < 287.5% Istisna  Istisna without parallel Istisna  Istisna with parallel Istisna 100% 20% N.A. 120% 100% Ijarah  Inventory  Operating Ijarah  IMB N.A. 100% 187.5% 100% N.A. 187.5% 200% 100% Musharakah300% - 400% 90% - 270% Depends on the underlying assets ≥ ( 300% - 400%) ≥ ( 90% - 207%) Mudarabah300% - 400% 90% - 270% Depends on the underlying assets ≥ ( 300% - 400%) ≥ ( 90% - 207%) * Capital charges do not include operational risk ** Provided the counterparty is unrated, otherwise the RW of the counterparty should be applicable Capital Charges* 15% 8% 23% < 23% 9.6% 8% 15% 16% 8% ≥ (24% - 36%) ≥ (7.2% - 21.6%) ≥ (24% - 36%) ≥ (7.2% - 21.6%)