IFC Conference 2012

Islamic Finance: Myths, Realities, and Best PracticesMarrakech, Morocco 27 & 28 December 2012

Basel III Effects on Islamic Banking

Early Capital Adequacy

Framework Proposal for IBs

The Rational for Basel III

Basel III in Islamic Banks

Dr. Elias Abu AL-Haija / Ass. Professor Emirate College of Technology UAE

The Rational

for Basel III

•  The first capital Accord. •  Established the requirement for

financial institutions to have total capital of at least 8% of risk-weighted assets (RWA).

Basel I

•  A d d e d a c a p i t a l c h a r g e f o r operational risk.

•  Required that supervisors focus on main risks in the banking system for calculating capital requirements.

•  Required enhanced disclosure requirements.

The Basel II framework

•  Requires banks to hold more capital.

•  And higher quality capital than the Basel II.

Basel III

Basle: Brief History

Basel I Basel I½ Basel II

Credit Risk Credit Risk Market Risk Credit Risk

Market Risk Operational Risk

1986 proposed 1993 proposed 1999 proposed

1988 effective 1998 effective 2007 effective

Basle: Brief History … Continues Consultative Paper (CP1) in Nov 18, 1999, and CP3 in July 2003

Volume Driven

Risk-Return Driven

Debt Crisis

Financial Crisis

Financial Innovations

Response Quality: Reactive

Response Quality: Reactive

Response Quality: Pro-Active

Basel III Higher Capital

Standard

requires a corresponding increase in Tier 1 capital

1986 proposed 2009 proposed

2013 effective

Basle: Brief History… Continues

Consultative Paper (CP) in Dec, 2009, and G.A in July 2010

Financial Crisis

Risk-Return Driven

Response Quality: More Re-Active

l  Limitations of Basel II. l  The global financial crisis of 2008. l  Lender of the last resort burdens

on government fiscal deficits. l  Lack of anti-cyclical protection. l  Reactive rather than proactive

regulation. l  Absence of stress testing.

?

The Rational for Basel III

Capital Adequacy

Requirements

for Basel III

l Banks must hold Minimum Common Equity (MCE) 4.5% of risk - weighted assets (RWA). Increased from 2% (Basel II) to 4.5%

@ As of 1 January 2013, banks will be required to have 3.5% MCE of RWA, 4% as of 1 January 2014 and 4.5% as of 1 January 2015.

CA Requirements for Basel III

l Tire I capital 6% to RWA (includes common equity, retained earnings and some reserves). Basel II, 4 %.

@ On 1 January 2013 Tier1 will increase from the current level of 4% to 4.5%, and to 5.5% on 1 January 2014. Finally, on 1 January 2015 it will increase to 6%.

CA Requirements for Basel III … Continues

l Additional Capital Buffers F Mandatory Capital Conservation Buffer of 2.5 %: ð The phase in starts from 1st January 2016 and

stretches up till 1st January 2019. ð Beginning with 0.625% of RWA on 1st

January 2016, it will notch up each year by 0.625% reaching the final level of 2.5% of RWA on 1st January 2019.

CA Requirements for Basel III … Continues

l Additional Capital Buffers…Continues FDiscretionary Countercyclical Buffer : which allows national regulators to require up

to another 2.5% (Within a range of 0% to 2.5%) of capital during periods of high credit growth.

CA Requirements for Basel III … Continues

l Minimum 3% Leverage Ratio. @ Equity to debt calculated. @ Bank liabilities, not RWA.

CA Requirements for Basel III … Continues

Liquidity provision

for Basel III

l Liquidity Coverage Ratio (LCR)

Bank to hold sufficient high- quality assets to cover its net cash outflows over a 30 day period.

It set to be introduced on 1 January 2015 after an observation period beginning from 2011.

Liquidity Provision for Basel III … Continues

Liquidity Coverage Ratio- LCR

Stock of high quality liquid assets Net cash outflows over a 30-day time period

˃ 100%

l Net Stable Funding Ratio (NSFR)

Available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

It will move to a minimum standard by 1 January 2018.

Liquidity Provision for Basel III … Continues

Net Stable Funding Ratio- NSFR

Available amount of stable funding Required amount of stable funding

˃ 100%

Liquidity concerns:

In the face of criticism that the proposed liquidity ratios (LCR & NSFR) could jeopardize the economy with capital being trapped in liquidity buffers, the committee has watered down the proposal and is phasing in the requirements only by 2015.

Basel II & Basel III

Basel II l  Recognition of different

types of risk. l  Collateral reduces credit

r i s k w i t h l o w e r r i s k weighting for residential mortgages.

Basel III l  Focus on counterparty

credit risk. l  Systemic risk recognized

after 2008 crisis. l  Excessive exposure to a

s i n g l e c o u n t e r p a r t y increases vulnerability.

l  Poss ib ly insuf f ic ien t attention to financing concentration.

Islamic Banks

and Basel III

l Islamic banks and the 2008 Crisis.

ð Conventional Bank, notably Leman Brothers, caused the crisis.

ð Unjust that Islamic banks should suffer the consequences.

ð Credit default swaps not permissible under Shari’ah.

Application to Islamic banks

l Islamic Finance part of global economy. ð Regulated with conventional banks. ð Financing concentration an issue for Islamic

Banks. ð Islamic bank depositors entitled to protection. ð Islamic finance should not be a burden on

government.

Application to Islamic banks

Capital Adequacy Proposal for Islamic Banks

Basel III

l Revised capital adequacy standards.

ªIssued 1st November 2012.

ªOriginal standards in IFSB 2, December 2005. Consultation: Public Hearing 1:18 November 2012, Dubai. Public Hearing 2:22 January 2013 in KL. Written submissions by 31 st March 2013.

IFSB* Exposure Draft 15

* IFSB: Islamic Finanaical Service Board

@ Equity based:

ªCould count as 1.5 % additional Tier 1 capital to RWA under Basel III.

ª Musharaka or Mudaraba structure.

@ Minimum maturity 5 years: ª Any amortization of principal within 5 year

period on straight line basis. ª No call expectation.

IFSB suggestion on additional capital in the form of Sukuk

@ Non distribution of profit:

This would not constitute a default event.

@ Sukuk unsecured and not guaranteed:

…IFSB suggestion on additional capital in the form of Sukuk

Built On The Performance Of Each Process

CASE STUDY

ADIB Basel III compliant Sukuk

Issuance:

ª Thursday 8 November 2012.

ª Arrangers HSBC, NBAD & Standard Chartered.

Financials: ª Issuance target $ 1 billion, order $15.5 billion. ª 330 investors: 38% Asia, 32% GCC, 26% Europe. ª Pricing 6.375% profit rate.

Case Study ADIB Basel III Compliant Sukuk

Structure:

ª Perpetual Murabaha Note. ª Profit reset after 6 years.

Tier I Qualifying Conditions: ª Deferral of profit payment mandatory if ADIB

breaches minimum capital requirements of UAE Central Bank or has inadequate liquidity .

ª Dividend stopper if breaches applied both to ordinary shares and the new Murabaha note, but later is senior.

Case Study ADIB Basel III Compliant Sukuk … Continues

for Basel III:

@ Mandatory and discretionary capital buffers of 2.5% of RWA.

Limits to pro-cyclicality in Islamic Finance: F Finance linked to investment in real assets. FLower proportion of funding from non-loss

absorbent demand deposits. FInvestment Mudaraba accounts can be

considered partially or wholly loss absorbent.

Pro-cyclicality In Islamic Finance

Definition:

Leverage is the equity to debt ratio.

Islamic Bank leverage ratio calculation: FPaid-up equity to demand deposit liabilities. FPaid-up equity to demand deposits plus

unrestricted Mudaraba deposits.

Leverage Ratios In Islamic Banks

Assets included:

FAssets financed by unrestricted accounts counted in the exposure calculation.

FAssets financed by restricted Mudaraba deposits not counted.

FLatter can be considered off-balance sheet.

Leverage Ratios In Islamic Banks….. continues

Result: FLeverage ratios lower for Islamic banks than

for conventional counterparts. FIslamic banks largely rely on retail deposits

rather than interbank market funding which is less stable.

Leverage Ratios In Islamic Banks….. continues

Sources of Funds for Islamic & Conventional Banks

Islamic bank Conventional bank Current Accounts Current Accounts

Savings Accounts Saving Accounts

Unrestricted Investment Time Deposits, Accounts (UIA) Certificate of Deposits…

Equity: Share Equity: Share Capital + Reserves → Tier 1 Capital + Reserves → Tier 1

Reserve (No Preferred Cumulative Preferred Shares or Subordinated Shares + Subordinated Debt allowed): → Tier 2 Debt → Tier 2

No Tier 3 Tier 3: portion of subordinated debt available only for market risk.

Counterparty credit risk weights for Islamic banking assets, %

Rating AAA A+ BBB+ BB+ Below to AA- to A- to BBB- to B- B- Sovereigns & central banks 0 20 50 100 150

Multilateral Development banks 20 50 50 100 150

Islamic & Conventional banks 20 50 100 100 150

Built On The Performance Of Each Process

The effect of

Basel III on I&C Banks

F Banks have argued that the changes to the capital rules could lead to huge funding gaps, with knock-on effects on economic growth.

F With the crisis in the euro zone adding to pressure on banks, France and Germany have been pushing for a window of up to 10 years before the Basel III rules are fully effective.

F German banks may need €105 bn more capital with Basel III.

Basel  III  designed  in  Swiss  style.  

*A  commi6ee  has  been  set  up  to  discuss  the  benefits  of  using  a  Mark  to  “how  you  feel  today”  accoun2ng.  methodology”  

Surrender monkey says: systemic risk has a hole

new flavor

Gogerty.com

9 years for implementation

No discussion of too big too fail

Counter cyclical buffers can be 0% No accounting

reform or harmonization*

Dr. Elias Abu AL-Haija