CAPITAL ADEQUACY FOR
INSTITUTIONS OFFERING
ISLAMIC FINANCIAL SERVICES
Basel II and the IFSB Standard
Simon Archer
University of Surrey
Consultant to IFSB
Contents of Presentation
• Capital adequacy regulation of
conventional banks: Basel I & Basel II
Pillar 1.
• Applicability to IIFS
• IFSB CAS methodology for calculating
capital adequacy
• Conclusions
2
Rationales for capital adequacy
regulation of conventional banks
• Role of equity capital in general: to absorb
unexpected losses
– Expected losses are covered by provisions
– Creditor protection
• Market forces & their limitations
• Economic versus regulatory capital in banks &
similar financial institutions
• Specific reasons for regulation of capital of such
institutions
– Systemic risk & social costs
– Deposit guarantee schemes and market failure
3
BCBS Approaches
• The BCBS general approach: CAR
– Definition of regulatory capital
– Risk-weighted assets (RWA); specification of Risk Weights
• Basel I (1988)
– Credit risk only
– Basic approach to risk weighting: standard weights
• 1996 Amendment for Market Risk
• Basel II (2004-5)
–
–
–
–
Regulatory capital versus economic capital
More sophisticated approach to credit risk
Capital requirement for operational risk
Market risk as per 1996 Amendment
4
The BCBS Capital Adequacy Methodology:
a Brief Reminder
• Capital Adequacy Ratio (CAR) = OC/RWA
– OC = Bank’s Own Capital
– RWA = Risk Weighted Assets
• Minimum CAR = 8%
• RWA approach designed for credit risk
• Maximum credit risk (normally) = RW of 100%
=> Capital Requirement (charge) = 8% of carrying value
of asset
• Certain credit risks (equity position risk in the banking
book and specialized lending ) have credit risk weighting
> 100%
• Market Risk & Operational Risk: capital requirement
established directly, then converted to credit risk
equivalent by multiplying by the reciprocal of 8%, i.e.
12.5
5
Application to Islamic Banks
• Comparison with conventional banks
–
–
–
–
IBs more similar to universal banks
But differences in funds mobilisation
Relevance for specification of CAR
Other factors affecting calculation of RWA
• Incidence of market (asset price) risk
– Liquidity risk
• Fundamental issues
– IBs and systemic risk/ contagious collapse
– PSIA, moral hazard & deposit guarantees
6
IFSB approach to measuring capital
adequacy
• The CAS approach to the measurement methodology
– Is largely based on the Basel approach, with the
necessary modifications and adaptations to cater for the
specificities and characteristics of the Shari’a compliant
products and services
– Uses risk weights derived from those proposed in Basel
II because of the lack of historical data
• to modify the risk weights for IIFS’ assets
• or to apply the IRB approach
Type of risk
Credit risk
Market risk
Operational risk
Approach from Basel II
Standardised approach (+ equity
position risk in banking book or
specialised lending)
1996 market risk amendment
Basic indicator approach
7
Some unique features addressed by
the IFSB CAS (1)
• Measuring RWA - catering for specific structure
and contents of Shari’a compliant products &
services (which are either asset-based, profitsharing or sukuk), but not specifically addressed
by the Basel guidelines.
– For example, in Murabaha or Ijarah, rather than
lending money, an IIFS has to acquire a physical
asset and then sell the asset back on credit or lease
it. The risk to which the IIFS is exposed transforms
from the price risk of holding physical assets at the
time of acquisition to credit risk at the time of sale on
deferred payment or on lease. Hence, the CAS is
structured in a matrix format to cater for the
transformation of risks at different contract stages.
8
Some unique features addressed by
the IFSB CAS (2)
– In measuring the capital requirements arising from of
the IIFS’s use of these contracts in its financing
activities, the resultant assets are risk-weighted
according to different risk categories - credit risk or
market (price) risk - taking account of the fact that the
category of risk may change according to various
stages of contracts.
9
Some unique features
addressed by the CAS (3)
• Measuring OC and RWA - Treatment of PSIA
and assets financed by PSIA in the Capital
Adequacy Ratio (CAR) calculation.
– Neither Restricted nor Unrestricted PSIA are part of
OC
– The IFSB Standard on Capital Adequacy incorporates
an investor protection approach in the treatment of
assets financed by IAH. Accordingly, these assets do
not normally attract any capital charges since the
IAH bear their own commercial risk & PSIA are not
part of OC.
10
The Discretionary Formula & the
Alpha Factor
– In certain circumstances, supervisors may exercise
discretion to require regulatory capital in respect of
credit & market risk of assets financed by PSIA,
because of Displaced Commercial Risk (DCR)
– DCR arises because IIFS may forego part or all of its
share of profit in order to smooth the rate of return to
IAH, in response to commercial pressure or
supervisory requirements, thus absorbing some of the
credit & market risk arising from PSIA-funded assets
– => increased risk for shareholders
– => need for additional capital in respect of PSIAfunded assets, subject to mitigation by special
reserves (PER) and also IRR
– Alpha is the proportion of PSIA-funded assets to be
included in the denominator of the CAR
11
Measurement of capital adequacy
for credit risk (1)
– Credit risk is generally measured according to
the Standardised Approach of Basel II, except
exposures arising from investments by means
of Musharaka or Mudaraba contracts in
assets that are not held for trading, which are
measured by using either
• One of the two methods et out in Basel II for
“equity position risk in the banking book”,
namely the simple risk weight method
• The method used in Basel II for “specialized
lending” (e.g. project finance), namely the
supervisory slotting method.
12
Measurement of capital adequacy
for credit risk (2)
– Until adequate historical data are available,
the IFSB standard uses the credit risk weights
set out in Basel II
• Those set out in the standardized approach for
assets other than Mudaraba and Musharaka
• The rates set out in Basel II for the two
methods mentioned above to be used for
Mudaraba and Musharaka contracts (subject to
risk mitigation)
13
Measurement of capital adequacy for
market risk (1)
• Equity position risk in the trading book:
– Specific risk - normally 8% capital charge on all
positions, supervisor may reduce to 4% for liquid &
diversified portfolio
– General market risk 8% on all positions on a marketby-market basis
– Special provisions for specific & general risks of
Sukuk held for trading
• Specific risk charge may be from zero to 1.6% for sovereign
and investment grade Sukuk depending on RW
• General market risk depends on residual term to maturity or
to next repricing date and may be from zero for a term < 1
month to 6% for a term > 20 years with 11 steps in between
14
Measurement of capital adequacy for
market risk (2)
• Foreign exchange risk (including gold and
silver) – 2 steps: measure
– Exposure in a single currency position (net open
position)
– Risks inherent in portfolio mix of long & short
positions (assets and liabilities plus off-balance sheet
positions e.g. guarantees) in different currencies
• ‘Shorthand method’ is recommended
• Net position in each currency is converted into reporting
currency at spot rates, and greater of net short or net long
positions is added to the net gold/silver position to derive net
overall position
• Capital charge is 8% of net overall position
15
Measurement of capital adequacy for
market risk (3)
• Commodities (price) risk: Maturity ladder or simplified
approach using standard unit of quantitative
measurement of weight or volume converted at spot
rates into the reporting currency
– Maturity ladder places net positions into 7 time-bands from 0-1
month to > 3 years for each commodity type
• Net quantitative amounts of matching long & short positions
are converted into the reporting currency at spot prices and a
capital charge of 1.5% is applied. Unmatched positions from
earlier time-bands may be carried forward and offset subject to
a 0.6% surcharge per time-band of carry-forward
• Any remaining net position receives a capital charge of 15%.
– Simplified approach applies a 15% capital charge to all net
positions, long or short, in each commodity plus an additional 3%
charge of 3% of the gross (long + short) positions
16
Measurement of capital adequacy for
market risk (4)
• The commodity exposures include those arising from inventory
(price) risk resulting from IIFS holding assets with a view to reselling or leasing them.
• Assets held in inventory with a view to resale or lease
receive a 15% capital charge
• In the case of equity investment made by means of Musharaka or
Mudaraba contracts where the underlying assets are
commodities held for trading, market risk measurements for
commodities are applicable
• ‘Commodity ladder’ approach, or
• Simplified approach
• The overall capital charge for market risk is converted into a ‘credit
risk equivalent’ by being multiplied by the reciprocal of the required
CAR, i.e.12.5 (100/8)
17
Measurement of capital adequacy
for operational risk
• The Basel methodology using the Basic Indicator
Approach (see next slide) involves multiplying
average gross income for the last 3 years by a
capital charge factor of 15%. The product is then
converted to a credit risk equivalent by
multiplication by a conversion factor, as for market
risk
– Shari’a compliance risk is a type of operational risk facing the
IIFS which can lead to non-recognition of income and resultant
losses.
– The extent of losses from non-compliance with Shari’a rules and
principles cannot be ascertained owing to lack of data.
– Supervisory authorities have discretion to impose a RW for
operational risk higher than 15% of average gross income as
they deem fit to cater for the Shari’a compliance risk of a
particular IIFS
18
Basic Indicator Approach
Annual Average Gross Income (previous three years) x
15%
• Gross income is defined as:
– Net income from financing activities (e.g. selling price
less purchase price) which is gross of any provisions,
depreciation and operating expenses; plus
– Net income from investment activities; plus
– Fee income (e.g. commission and agency fee)
Less:
– Investment account holders’ share of income
• The result is converted to a ‘credit risk equivalent’ as for
market risk
19
Treatment of Equity of Investment Accounts
Standard & Alternative Formulas
• Standard formula – assumes that:
– 100% of credit & market risk of risk weighted
assets financed by IAH funds is borne by IAH
– 100% of operational risk of managing these
assets is borne by IIFS
• Alternative formula, at supervisor’s discretion –
– Some proportion α (decided by supervisor) of
credit & market risk of risk weighted assets
financed by IAH funds is deemed to be borne by
IIFS (displaced commercial risk)
– 100% of operational risk of managing these
assets is borne by IIFS
20
Capital Adequacy Ratio Formulas
Standard formula
Eligible Capital (Tiers 1 + 2)
Divided by
Total RWA *(CR+MR+OR) less RWA funded by PSIA *(CR+MR)
Notes:
1.
PSIA include (a) Invested Capital less losses (b) PER of PSIA
available for distribution (c) IRR
2.
The RWA equivalent of the OR for PSIA-funded assets remains in
the denominator, but the RWA for CR and MR are removed
21
Capital Adequacy Ratio Formulas
Alternative formula (at supervisor’s discretion)
Eligible Capital (Tiers 1 + 2)
Divided by
Total RWA (CR+MR+OR)
less RWA funded by restricted PSIA (CR+MR)
less (1-a) RWA funded by unrestricted PSIA (CR+MR)
less (a) RWA funded by PER and IRR (CR+MR)
Note: In contrast to the standard formula, the effect of this is to leave a
proportion α (alpha) of RWA(CR+MR) for unrestricted PSIA as part of
the denominator, with an adjustment for RWA financed by reserves
PER & IRR within equity of IAH which absorb risk.
Alpha is set by the supervisor
22
CAR Calculation Example (1)
Standard Formula
•
•
•
•
Eligible Capital Tiers 1 + 2 = 8
Credit RW Assets = 40
Market RW Assets equivalent = 40,
Operational RW Assets equivalent = 20
Subtotal = 100
• Assets funded by PSIA = 70% of total on- and
off-balance sheet assets (Unrestricted = 20%,
Restricted = 50% and are off-balance sheet)
CAR = 8 / [100 – 0.7*(40+40)] = 8 / 44 = 18.2%
23
CAR Calculation Example (2)
Supervisory Discretion Formula
• Assume eligible capital = 8, alpha = 30%, and
PER + IRR = 10% of unrestricted PSIA
• Restricted PSIA (20%)
• Unrestricted PSIA (50%)
• All other funds (30%)
• Total = 100
20%
CRWA
8
MRWA equ . 8
ORWA equ. 0
Totals
16
50%
30%
Total
20
20
0
40
12
12
20
44
40
40
20
100
24
Supervisory Discretion Formula
Calculation continued
CAR =
EC = 8
divided by
[Total RWA = 100
Less CRWA and MRWA equiv of Restricted PSIA =
8+8 = 16
Less (1-alpha)* CRWA and MRWA equiv of
Unrestricted PSIA = (1-0.3)*(20+20) = 28
Less alpha*(PER+IRR) = 0.3*0.1*(20+20) = 1.2]
8/(100 – 16 – 28 – 1.2) = 8/54.8 = 14.6%
25
Supervisory Discretion Formula
Calculation continued (2)
• If alpha is set equal to 1, CAR becomes:
EC = 8
divided by
[Total RWA = 100
Less CRWA and MRWA equiv of Restricted PSIA =
8+8 = 16
Less (1-alpha)* CRWA and MRWA equiv of
Unrestricted PSIA = (1-1)*(20+20) = 0
Less alpha*(PER+IRR) = 1*0.1*(20+20) = 4]
8/(100 – 16 – 0 – 4) = 8/80 = 10%
26
CAR Calculation
• Basel II formula EC/RWA could be interpreted in different
ways for IIFS, in absence of IFSB guidance
• EC/RWA and equiv. funded by shareholders’ funds
+ other funds + ORWA equiv. (all PSIA being
excluded except for OR)
= 8/(100 – 16 - 40) = 18.2% (as with standard
formula)
• EC/RWA and equiv. funded by shareholders’ funds
+ other funds + Unrestricted PSIA + ORWA equiv.
(Restricted PSIA being excluded except for OR,
Unrestricted PSIA being treated as liabilities)
= 8/(100 - 16) = 9.5% (this differs from discretionary
formula with alpha = 1; no PER/IRR adjustment)
27
Comments on Displaced
Commercial Risk
• Juristic nature of PSIA: profit sharing &
loss bearing. BUT
• Unrestricted PSIA holders & risk appetite
• Smoothing of PSIA returns
• Constructive obligation & capital certainty?
• Deposit guarantee schemes (Takaful or
provided gratis by central bank)?
28
The economic characteristics of
PSIA
• Complex
– May vary between jurisdictions
– In no cases are they part of bank’s capital
– Juristically should be available to absorb all losses on
PSIA-funded assets (exc. misconduct & negligence)
– In practice, may be assimilated to conventional
deposits
– May even be covered by deposit guarantee schemes
• Implications for IB’s capital adequacy & for
calculation of CAR - see Alternative Formula
29
RWs for profit-sharing assets (1)
• Musharaka and Mudaraba financing
assets not easily accommodated within
Basel credit risk methodology
• When assets owned by the Musharaka or
Mudaraba are commodities or other
trading assets, market risk
• When M or M used as a means of
financing and to be held to maturity, credit
risk (capital impairment)
30
RWs for profit-sharing assets (2)
• Credit risk measurement methods from
Basel II that are included in IFSB Standard
– Equity position risk in the ‘banking book’:
market-based approach
• High RWs: 300% +
– ‘Risk Slotting Criteria’ for specialised lending
• Lower RWs, but needs involvement of Banking
Supervisor
• Importance of credit risk mitigating
structures
31
Examples of specific requirements
Credit Risk with Market Risk (1)
• Mudarabah & Non-binding MPO
– Need to provide 15% capital charge (= 187.5 RW) for
price risk on any assets held pending completion of
sale to customer
– Replaced by credit risk weight on the receivable when
sale takes place
• MPO
– Assets held pending completion of sale to customer
receive RW of 100% applied to the net amount of
acquisition cost less resale value and less any HJ
deposit paid by customer (normally this net amount
would be zero or very small)
32
Examples of specific requirements
Credit Risk with Market Risk (2)
• Salam with Parallel Salam
– Purchase price (Salam capital) attracts RW of Salam
counterparty subject to any risk mitigation. No netting against
debt due to Parallel Salam counterparty.
– Long positions in commodity from Salam are netted against
short positions in same commodity from Parallel Salam and the
net positions are subject to market risk capital charge based on
either Maturity Ladder (with time-bands) or Simplified Approach
(15% on net position + 3% on gross position)
• Salam without Parallel Salam
– Salam capital attracts RW of Salam counterparty subject to any
risk mitigation.
– Long position in commodity attracts 15% capital charge
33
Examples of specific requirements
Credit Risk with Market Risk (3)
• Istisna’a with Full Recourse to the Ultimate
Customer & Parallel Istisna’a
– Unbilled WIP inventory
• Credit risk: RW of ultimate customer
• Market risk: nil, provided price variations by P.I. supplier can
be passed on to ultimate customer
• Possible operational risk re price variations that cannot be
passed on (error in drawing up contracts)
– Receivables under contract billings
• Credit risk: RW of ultimate customer
– No netting of receivables from ultimate customer and
payables to P.I. supplier
34
Examples of specific requirements
Credit Risk with Market Risk (4)
• Istisna’a with Full Recourse to the Ultimate Customer,
without Parallel Istisna’a
– Unbilled WIP inventory
• Credit risk: RW of ultimate customer
• Market risk: 1.6% capital charge (= 20% RW)
– Receivables under contract billings
• Credit risk: RW of ultimate customer
• Limited & Non-Recourse Istisna’a with Parallel Istisna’a
(Project Finance)
– Unbilled WIP inventory & Receivables under contract billings
• Credit risk: RW based on ECAI rating of project if available,
otherwise on Supervisory Slotting Criteria (RW 70% – 250%)
• No netting of receivables from ultimate customer and payables
to P.I. supplier
35
Examples of specific requirements
Credit Risk with Market Risk (5)
• Operating Ijarah
– With binding PL
• Credit risk: Assets held pending signature of lease contract with
customer receive RW of 100% (or customer’s RW if lower) applied to
the net amount of acquisition cost less resale value and less any HJ
deposit paid by customer
– Non-binding PL
• Market risk: Carrying value of assets held pending signature of lease
contract with customer attracts 15% capital charge
– Both binding and non-binding PL
• Credit risk: After signature of lease contract, total estimated value of
lease receivables remaining payable for whole duration of contract,
less recovery value of the asset, is treated as receivable from the
lessee and receives RW of lessee as obligor
• Market risk: During contract – carrying (recovery) value of asset is risk
weighted at 100%. End of contract pending re-lease or disposal carrying value of asset attracts 15% capital charge.
36
Examples of specific requirements
Credit Risk with Market Risk (6)
• Ijarah Muntahia Bittamleek
– With binding PL
• Credit risk: Assets held pending signature of lease contract
with customer receive RW of 100% (or customer’s RW if lower)
applied to the net amount of acquisition cost less resale value
and less any HJ deposit paid by customer
– Non-binding PL
• Market risk: Carrying value of assets held pending signature of
lease contract with customer attracts 15% capital charge
– Both binding and non-binding PL
• Credit risk: After signature of lease contract, total estimated
value of lease receivables remaining payable for whole
duration of contract, less recovery value of the IIFS’s share of
asset*, is treated as receivable from the lessee and receives
RW of lessee as obligor. (No market risk)
• *In some forms of IMB, ownership of asset is transferred
progressively to lessee
37
Examples of RW for Profit-Sharing
Financing Assets (1)
• Musharakah
– Private commercial enterprise to undertake trading
activities in FX, securities or commodities
• Market risk of underlying assets
– Other private commercial enterprises
• Contributed capital less reductions in Diminishing
Musharaka, Credit RW as follows: Either
– Equity position in banking book: 400% RW subject to risk
mitigation, or
– Supervisory slotting: 90%-270% RW
– Joint ownership of real estate or movable assets
• Credit risk: RW based on customers in underlying
subcontracts (Ijarah, IMB or Murabahah)
• Market risk: as in underlying subcontracts, otherwise capital
charge as for underlying assets
38
Examples of RW for Profit-Sharing
Financing Assets (2)
• Mudarabah
– Private commercial enterprise to undertake
trading activities in FX, securities or
commodities
• Market risk of underlying assets
– Other private commercial enterprises
• Contributed capital less reductions in
Diminishing Musharaka, Credit RW as follows:
Either
– Equity position in banking book: 400% RW subject to
risk mitigation, or
– Supervisory slotting: 90%-270% RW
39
Examples of RW for Profit-Sharing
Financing Assets (2)
• Mudarabah (continued)
– Mudarabah for Project Finance
• Credit risk::
• on progress payments due from the ultimate customer
following certification of work,
– subject to binding agreement with ultimate customer
to make progress payments into a ‘repayment
account’ with the IIFS, RW is based on rating of
ultimate customer.
– If no such agreement, RW is based on Mudarib’s
credit rating (or 100% RW)
• on balance of amount advanced to and due from
Mudarib, RW is 400% (equity position risk) or based on
the supervisory slotting method (RW 90%-270%).
40
Sukuk held in the Banking Book
(not for trading)
• Externally rated:
– Credit RW based on ECAI rating as per standardised
approach
– No market risk
• Not rated:
– Credit RW based on RW of issuer if recourse to
issuer, otherwise based on RW for underlying contract
– Market risk capital charge, where applicable, based
on capital charge for underlying contract
41
Conclusions
• IFSB CAS needed to extend & adapt Basel II
approach to cater for:
– Characteristics of Islamic financing assets which may
involve
•
•
•
•
several stages of contract execution
market as well as credit risk
equity position risk in the ‘banking book’
different forms of and limitations on collateral
– Financing by Profit Sharing and Loss Bearing
Investment Accounts
• Especially unrestricted IAH
• Issue of Displaced Commercial Risk
42