I
Outline
Regulatory capital requirements
1- Capital Management : Differences between Conventional and
Islamic Finance
2- Impact on the Islamic capital requirement
3- Overall assessment
Capital Management in Islamic Finance 2 Raed H. Charafeddine Banque du Liban
II
Liquidity buffers requirements
1- Liquidity risk and types
2- Impact on the Islamic liquidity requirement
3- Overall assessment
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I.1- Different Types of Risks between Conventional
and Islamic Financial Institutions
Conventional Banking
Islamic Banking
Credit Risk Credit Risk
Market Risk Market Risk
Liquidity Risk Liquidity Risk
Operational Risk Operational Risk
_ Displaced Commercial Risk
_ Legal and Shari’ah Risk
Capital Management in Islamic Finance 3 Raed H. Charafeddine Banque du Liban
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I.1- Implications of Profit –Sharing Investment
Accounts on Capital Adequacy
Capital Management in Islamic Finance 4 Raed H. Charafeddine Banque du Liban
Unrestricted Profit Sharing
Investment Accounts
Deposit-Like Product
(Implicit Fix Return and Capital guarantee)
Investment Product
(Variable Return, Non-Capital Guaranteed)
Characteristics and Supervisory
Considerations
Risks
Risks borne by shareholders
Risks borne by Investment Account
Holders except in the case of negligence and/or misconduct
Implications on Capital Adequacy
0
1
α
Products
Source: Supervisory, regulatory, and capital adequacy implications of profit –sharing investment accounts in Islamic Finance, ( Archer , Abdel Karim and
Sundararajan 2010)
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I.5 - Implications of the supervisory determination of
the α factor
Capital Management in Islamic Finance 5 Raed H. Charafeddine Banque du Liban
0 1
Capital Adequacy Ratios are highly sensitive to α factor
α
If supervisory
authorities act as
though α is equal
to 0 when it
should be close
to 1
If supervisory
authorities act as
though α is close
to 1 when it
should be close
to 0
Islamic banks
are significantly
undercapitalized
Islamic banks
carry excess
amounts of
capital which
will affect their
competitiveness Source: Supervisory, regulatory, and capital adequacy implications of profit –
sharing investment accounts in Islamic Finance, Archer – Abdel Karim and Sundararajan (2010)
I.2- Conventional and Islamic Capital Requirement
Reforms: Timelines
Capital Management in Islamic Finance 6 Raed H. Charafeddine Banque du Liban
International
Convergenc
e of
Capital
Measureme
nt and
Capital
Standards
June 2006
Proposed
revisions to the
Basel II Capital
Markets Risk
Guidelines for
Computing Capital
for Incremental
Risk in the Trading
Book
June 2011
Basel III: A global
regulatory
framework for more
resilient banks and
banking systems -
Revised version
December 2010
Guidance for
national authorities
operating the
countercyclical
capital buffer
Enhancements to
the Basel II
framework
Revisions to the
Basel II market
risk framework
Guidelines for
computing capital
for incremental
risk in the trading
book
July 2008
Global Systemically
Important Banks :
Assessment methodology
and the additional loss
absorbency
Nov. 2011
IFSB-2
Capital
Adequacy
Dec. 2005
IFSB-7
Capital Adequacy
Requirements for
Sukuk,
Securitization and
Real
Estate Investments
Jan. 2009
ED-15:
Revised
Capital
Adequacy
Standard for
Institutions
Offering
Islamic
Financial
Services
Nov. 2012 Mar. 2008
GN1
Recognition
of ECAIs on
Shariah
Compliant
Financial
Instrument
GN 2
Commodity
Murabaha
Transactions
GN 3
Practice of
Smoothing the
Profits Payout to
Investment Account
Holders
July 2009
Mar. 2011
GN4
The determination
of Alpha in the
Capital Adequacy
ratio for IIFS
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
7 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
A. Increase in bank’s capital quality,
consistency and transparency
• Greater focus on Common Equity;
Tier 2 simplified (no upper & lower) ;
Tier 3 will be phased out;
• Innovative Hybrid capital instruments
with an incentive to redeem will be
phased out;
• Stricter Definition through stringent
deductions.
Impact on Islamic Prudential
Regulation (PED 15)
A. Increase in bank’s capital quality,
consistency and transparency
• Criteria for Common Equity Tier-1,
Additional Tier-1 and Tier-2, in line
with Basel III. PSIA are not qualified
as part of the core or additional
capital. PER and IRR may not be
included in any Tier of the capital.
• Inclusion of hybrid Sukuk as well as
Convertible Contingent Capital
(CoCos) for IIFS. Subordinated
Sukuk in principle are impermissible.
• Inclusion of Zakat Deduction under
Regulatory adjustments/deductions.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
8 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
B. Credit Risk Weights
•Credit conversion factors (CCF) for off
balance sheet items have been made
uniform at 50%, regardless of the maturity
of the liquidity facility.
Impact on Islamic Prudential
Regulation (PED 15)
B. Credit Risk Weights
• Eligible lines of financing less than one
year still receive a 20% CCF
•Credit Risk Mitigation Techniques :
Enlarged scope to cover on-balance
sheet netting
•Explanation of multiple CRM to cover a
single exposure
• A more specific reference to export
guarantee schemes used by IIFS to
cover their trade financing netting.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
9 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
C. Market Risk Weights
•Equity Position Risk : capital charge for
specific and general market risks have
been made uniform at 8% for all types of
portfolios.
•Advanced techniques.
• Calculate specific risk capital charge for
the “correlation trading portfolio”.
•Revised method of calculating specific
risk capital charge for the securitisation
positions in the trading book.
Impact on Islamic Prudential
Regulation (PED 15)
C. Market Risk Weights
•Equity Position Risk : Same capital
charge for specific and general market
risks.
• IRB approaches not covered.
•Include the duration method for the
calculation for trading positions in Sukuk.
•Revised method of calculating specific
risk capital charge for the securitisation
positions in the trading book .
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
10 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
D. Operational Risk Weights
Impact on Islamic Prudential
Regulation (PED 15)
D. Operational Risk Weights
• Not covered Advanced Measurement
Approach.
• Same eight lines of business and
percentages of annual gross income
(called beta).
• Allocating additional capital may not be
the optimal solution for covering Shari’ah
non-compliance risk, fiduciary risk and
legal risk as a part of operational risk.
Instead list of Shariah requirements and
explanation of unique operational risk
per type of instruments have been
provided.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
11 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
E.
Impact on Islamic Prudential
Regulation (PED 15)
E. Adjusting the denominator for PSIA
• No change in the calculation of the
alpha factor
•CMT and Other deposits : important
capital adequacy issues associated with
such transactions are included
•Wakalah and Musharakah as PSIA :
Distinct features and treatment.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Global Financial Reforms : How Did they impact the IFSI ?
12 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
F.
Impact on Islamic Prudential
Regulation (PED 15)
F. Minimum Capital Requirement for
Islamic Financing Assets
• Coverage of the capital treatment of
CMT, and Qard ul Hassan, Wakalah.
• Coverage of the capital treatment of
Shari’ah compliant derivatives.
• Capital requirements for exposures of
IIFS related to real estate financing and
investment activities.
• Capital adequacy treatment of an IIFS’s
involvement in Sukūk issuance and
securitisation processes in various
capacities, including as originator,
servicer and credit enhancer.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Is there an impact for IFSI?
Capital Management in Islamic Finance 13 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
G. Increase in the required level of
capital • Increase of the minimum common
equity requirement from 2%
(equivalent to 1% according to the
new def) to 4.5%;
• Increase of the Tier 1 minimum
capital requirement from 4%
(equivalent to 2% according to the
new def) to 6%;
• Additional Capital conservation
buffer of 2.5% of common equity to
withstand future periods of stress;
The required total common equity
will be brought to 7%, Tier 1 capital
8.5% and Total Capital 10.5%.
Impact on Islamic Prudential
Regulation (PED 15)
G. Increase in the required level of
capital
• Same increase in the required
level capital.
• Same requirement for the Capital
Conservation buffer and
minimum capital conservation
ratios.
• Same requirement for the
preparation of a Capital
Conservation Plan on a
contingency basis.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Capital Management in Islamic Finance 14 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
H. Introducing a non-risk-based
leverage ratio
Simple leverage Ratio, as a backstop
to the Risk based capital measure
Tier1/Assets > 3%
Impact on Islamic Prudential
Regulation (PED 15)
H. Introducing a non-risk-based
leverage ratio
Same computational details for the
leverage ratio.
I.2- Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Capital Management in Islamic Finance 15 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
I. Macroprudential Overlay for the
Reduction of Systemic Risk
• Reduce procyclicality : Introducing
the countercyclical capital buffer
calibrated in a range of 0 - 2,5% that
would require institutions to build up
defensive buffers in good times that
could be drawn down in bad times.
Implications on Islamic Prudential
Regulation (PED 15)
•Increased pro-cyclicality of IBs due to:
o In buoyant economic conditions : capital ratio are
enhanced as a result of increased profits , which
leads to higher reserves, lower requirement of
provisions against impairments and lower RWs
being applied to banking book assets.
oTendency to invest in real sector-related asset
classes may expose to cyclical impact of the
economic cycle in countries dependent on oil.
o The relying on External Credit Assessment
Institutions (ECAI) rating for the determination of
the risk weights.
oThe growing practice of raising term deposits and
making term loans based on reverse murabaha or
tawaruq transactions reduced the profit and loss
sharing financing forms.
Maintain counter-cyclical buffer under Pillar
II in line with Basel III.
I.2. Global Financial Reforms toward enhancing
regulatory capital: Impact on IFSI regulation
Capital Management in Islamic Finance 16 Raed H. Charafeddine Banque du Liban
BASEL III New Capital
Requirement
J. Macroprudential Overlay for the
Reduction of Systemic Risk
• Account for the interlinkages and
common exposures: Additional loss-
absorbing capacity for Systemically
Important Financial Institutions
(systemic capital surcharge).
• Further guidance on Regional and
Domestic SIFIs will be provided.
K. Sufficient time for a smooth
transition
Impact on Islamic Prudential
Regulation
J. Macroprudential Overlay for the
Reduction of Systemic Risk
• No guidance on the treatment of the
G-SIFIs because no IIFS is listed
among the 29 G-SIFIs issued by the
Basel Committee.
• Further guidance on Regional and
Domestic SIFIs will be provided once
an agreement will be reached on the
global level.
K. Sufficient time for a smooth
transition
Capital Management in Islamic Finance 17 Raed H. Charafeddine Banque du Liban
• Empirical data shows that most IIFS will not face a major difficulty meeting
2.5% capital conservation buffer requirement out of their CET1, above the
regulatory minimum capital requirements. As most of the capital of IIFS is
composed of common equity in many jurisdictions, IIFS will naturally be in a
good position to meet this requirement.
• IIFS will have to account for major considerations for issuance of contingent
convertible capital, among others:
•Which Shari’ah compliant structure will be most suitable?
•When will the Sukuk qualify for Additional Tier 1 or Tier 2?
•How to avoid element of gharar (excessive uncertainly)?
•What type of trigger to be used?
•What should be the conversion rate?
I.3 Overall assessment of the new capital
requirements for IIFS
Capital Management in Islamic Finance 18 Raed H. Charafeddine Banque du Liban
• For various reasons, pro-cyclicality may be considered to be a less serious
problem in the IIFS than in conventional banks. The concept of
countercyclical buffer is also quite implementable on the IIFS.
• Most IIFS will not face any difficulty in meeting the leverage ratio as their
current leverage ratio is well below the 3%.
• IIFS can be considered having its important and interconnectedness at a
level that its insolvency can impact global financial system. Therefore, the
issue of Global SIFIs is not very relevant to the IIFS.
• DCR Estimation should be based on Supervisory rules and not just on a
discretion basis. Clearer methodology and data requirement should be made
available.
I.3 - Overall Assessment of New Capital
Requirements for IIFS
II.1. Liquidity Risk and Types
Global Financial Reforms : How Did they impact the IFSI ?
19 Raed H. Charafeddine Banque du Liban
Funding Liquidity Risk
Bank is unable to meet its financial
obligations without affecting either daily
operations or the financial conditions.
Market Liquidity Risk
Bank is unable to unwind or offset
outstanding positions in the market
within a short span of time at or
near the previous market price
because of inadequate market
depth or market disruption.
II.2- Conventional and Islamic Liquidity Management
Reforms: Timelines
Capital Management in Islamic Finance 20 Raed H. Charafeddine Banque du Liban
Sound
Practices for
Managing
Liquidity in
Banking
organizations
Feb. 2000
Liquidity Risk
Management
and Supervisory
Challenges
Dec. 2010
International Framework
for liquidity risk
measurement standard
and monitoring
Dec. 2009
Guidelines on
liquidity Buffers &
Survival Periods
Principles for
sound liquidity risk
management and
supervision
Feb. 2008
Revised full text on
Basel III liquidity
requirements
Jan. 2013
IFSB-12: Guiding Principles
on Liquidity Risk Management
for Institutions offering Islamic
Financial Services
Sep. 2008
Principles for
sound stress
testing practices
and Supervision
May.2009
Mar. 2012
IFSB-13: Guiding Principles
on Stress Testing for
Institutions offering Islamic
Financial Services
TN-1: Technical note on
issues in strengthening
liquidity management of
Institutions offering Islamic
Financial Services : The
development of Islamic Money
Markets
Mar. 2008
IFSB-1: Risk
Management
Dec. 2005
II.2. Global Financial Reforms toward enhancing
liquidity buffers: Impact on IFSI regulation
Capital Management in Islamic Finance 21 Raed H. Charafeddine Banque du Liban
BASEL III new global minimum
liquidity standards
•New liquidity coverage ratio : promoting
short-term resilience by ensuring that it
holds a buffer of high-quality liquid assets
to deal with cash outflows in an acute
stress scenario lasting for one month.
LCR = Stock of high quality liquid assets /
Total net cash outflows overt the next 30
calendar days ≥ 100%
•New Net Stable Funding Ratio: address
funding mismatches over a time horizon of
one year and provide incentives to banks
to use stable sources to fund their
activities.
NSFR = Available amount of stable
funding / Required amount of stable
funding > 100%.
Impact on Islamic Prudential
Regulation
• Currently Guiding Principles for
Liquidity Risk management for IIFS
and supervisors only.
• Suggested metrics and monitoring
tools are the same.
• IFSB is working on the preparation of
a separate Guidance Note on
quantitative tools for the
measurement and monitoring of
liquidity risk in IIFS, in line with
industry practices and other global
initiatives.
Capital Management in Islamic Finance 22 Raed H. Charafeddine Banque du Liban
Islamic banks will face serious challenges to comply with the Basel III liquidity
requirements due to :
- the shortage of high quality liquid Islamic assets,
- the shortage of stable retail funding v/s wholesale funding which is still
significant small in comparison to the bank’s operations size,
- Low reliance on repurchase markets for interbank funding due to the slow
progress and disagreements on the possible alternatives to a Shariah
compliant repurchase agreement.
The overall impact will be the following:
• Increased cost of liquid funds as demand increases.
• IIFS income will be reduced as bank invests in more liquid investments and
reduce financing maturity to match available stable funding.
II.3 Overall assessment of the impact of Liquidity
requirements for IIFS
Capital Management in Islamic Finance 23 Raed H. Charafeddine Banque du Liban
CONCLUSION
Three main takeaways :
1- Building a fail-safe financial system is impossible.
2- If the reform process can identify and mitigate these systemic risks,
the overall system will be more resilient.
3- Aligning the IFSB Standards and Guidelines with Global Capital and
Liquidity standards provides a level playing field to the IIFS vis-a-vis
market players.