Capital Adequacy
Framework for Islamic
Banks
Dr. Habib Ahmed
Lecture Plan



Background
Need for Bank Regulation
Banking Regulatory Frameworks
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Basel I (1988)
Basel II (2006)
Regulatory Framework of Islamic Banks—
IFSB Approach (2005)
Conclusion
2
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)
3
Background (2)
Assets
Assets
Liabilities
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
4
Role of Capital
Examples:
Case 1: E=10
State 0:
A=100,
State 1:
A=95,
State 2:
A=85,
Case 2: E=20
State 0:
A=100,
State 1:
A=95,
State 2:
A=85,
L=90, E=10;
L=90, E=5;
L=90, E=-5; (Bankrupt)
L=80, E=20;
L=80, E=15;
L=80, E=5
More risks need more capital (to avoid bankruptcy)
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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
6
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.
7
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.]
8
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%
9
Capital Requirements—
Example
Assets
Liabilities
Cash
5,000 Deposits/Debt
Govt. Bonds
20,000 Total Capital
Deposits at Banks
5,000
Loans for Residential
Properties
10,000
Loans to Private
Corporations
60, 000
Total
100,000 Total
95,000
5,000
100,000
10
Capital Requirements—
Example (contd…)
0% Risk Weight
Cash
Govt. Bonds
20% Risk Weight
Balances with Banks
50% Risk Weight
Loans for Residential Properties
100% Risk Weight
Loans to Private Corporations
Total Risk Weighted Assets
5,000
20,000
25,000 x 0 = 0
5,000
5,000 x 0.2 = 1000
10,000
10,000 x 0.5 = 5000
60,000
60,000 x 1.0 = 60,000
66,000
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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%
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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%
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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)
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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.)
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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]
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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
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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:
Credit Assessment
AAA to
AA-
A+ to A-
BBB+ to
BB-
Below
BB-
Unrated
Risk Weight
20%
50%
100%
150%
100%
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Basel II Standards—
Market Risks
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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.)
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Basel II Standards—
Operational Risks
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Operational Risk—three approaches
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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 %
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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
21
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)
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Typical IB Model
Balance Sheet
Assets
Liabilities
Banking
Portfolio
Deposits &
Debt
Trading
Portfolio
Reserves
Equity
 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)
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Issues in Capital Adequacy for IBs
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Asset side:
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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
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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.
25
Capital Requirements—
Example (1): Salam contract
Applicable Stage of
the Contract
Credit RW
Market Risk Capital
Charge
Payment of Purchase Price
by the IIFS to a Salam
customer
Based on customer’s rating
or 100% RW for unrated
customer
The Simplified Approach
15% capital charge on long
position of salam exposures
Receipt of the purchased
commodity by the IIFS
Not Applicable
The purchased commodity is
sold and delivered to a buyer
Not Applicable
Not Applicable
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Capital Requirements— Example
(2): Operating Ijarah
Applicable Stage
of the Contract
Credit RW
Market Risk
Capital Charge
Asset available for lease
(prior to signing a lease
contract
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
Non-binding PL
15% capital charge until
lessee takes possession
Upon consigning a
leasing contract and the
lease rental payments are
due from the lessee
Total estimate value of the lease
receivables shall be risk-weighted
according to the lessee’s rating. 100%
RW for unrated customer
The residual value will be
risk-weighted 100%
Maturity of the contract
term and the leased asset
is returned to IIFS
Not applicable
15% capital charge of the
carrying value of the asset
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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)
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IFSB Standards-Example (1)
Assets
Cash
Total Assets
Liabilities
10
90
PSIA
Demand Deposits
Equity
40
55
5
 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%
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IFSB Standards-Example (2)
Assets
Cash
Total Assets
Liabilities
10
90
PSIA
Demand Deposits
Equity
20
75
5
 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%
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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

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Thank you!
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