Prudential Regulation of Islamic Banks: An Analysis of Capital Adequacy Standards

1. Prudential Regulation ofIslamic Banks: An Analysis ofCapital Adequacy Standards Group 2 Haris, Rusli, Rahma, Soleh Vani

2. INTRODUCTION • BisnisPerbankan : terdiriatasresikoberupaprospekkeuntungandankerugian • Regulator menerapkanprinsip yang samadalampenangananrisikountuksemua bank, termasuk bank yang beroperasidenganhukum Islam. • Oleh karena itu penting bahwa persyaratan peraturan harus disesuaikan untuk mengakomodasi karakteristik unik dari perbankan Islam. • Industri ini menghadapi tantangan untuk mengembangkan standar peraturan yang seragam yang disesuaikan dengan fitur khusus pembiayaan Islam

3. Capital Adequacy • A key to current prudential regulation is the obligation to continuallymeet minimum capital ratios, as solvency risk is ultimately concernedwith the question of banks capital adequacy (Dale, 1984:58). It isimperative that banks total risk exposure should be identified,measured in some useful operational way, and evaluated in the lightof banks capital cushion • In the broadest terms, capital is adequate either when it reducesthe chances of future insolvency to somepredetermined level or,alternatively, when the premium to be paid by banks to an insurer isafair (Gardener, 1986:19). • The objective is to ensure that banksÕ capital will be adequate toabsorb their losses (Nwankwo, 1990: 38f., and Dale, 1984:57).

4. Without sufficient capital even the most conservatively run banking institutions cannot survive. Experience has shown thatcapital and its allocation gets rather a low priority from most small tomedium-sized emerging market banks, including Islamic banks(Jackson-Moore, 2002). This puts a greater onus on regulatoryauthorities to ensure that regulations do capture the risks. It alsomeans that, where institutions are operating in ways that introducenew risks, authorities are aware of this and are able to takeappropriation action.

5. III. Basle Accord • In 1988, the Basle Committee published its most important initiativeguidelines on prudential regulation entitled ÔinternationalConvergence of Capital Measurement and Capital StandardsÕ (BasleAccord). The standard is underlined by the assumption that banksÕstrength and safety is importantly related to the size of their capitalbase (UNCTAD, 1992:35). The Basle Committee believes that it is ofgreat importance that the capital adequacy framework should coverall off-balance-sheet activities. The CommitteeÕs approach is that alloff-balance-sheet activities are to be converted to credit riskequivalent. This is achieved by multiplying the nominal principalamounts by a credit conversion factor: the resulting amounts thenbeing weighted according to the nature of the counter party (BasleCommittee, 1988: Annex 2).

6. III. Basle Accord • The Basle committee bases its definition of capital on a two partconstituent: • (i) Tier 1 (core) capital stock issues as well as disclosed reserves • without any limit. • (ii) Tier 2 (supplementary) capital perpetual securities, undisclosedreserves, subordinated debt with maturity exceeding five years, andshares redeemable at the option of the issuer.5 • Tier 1 must constitute at least 50 per cent of total capital, whileTier 2 capital cannot exceed 100 per cent of Tier 1 capital as acontribution to total capital. Moreover shares redeemable at theoption of the issuer and subordinated debt cannot exceed 50 per centof Tier 1 capital (Basle Committee, 1988).

7. III. Basle Accord • The Basle Accord establishes a scheme whereby capital adequacyof banks is based on an overall minimum ratio of 8%6 in whichcapital and off-balance-sheet exposures are related to differentcategories of weighted risk. A bank’s capital base is related to its riskweighted assets. In differentiating between the categories of assetriskiness, higher risk assets are assigned corresponding higherpercentage capital loading; that is, they accordingly require morecapital adequacy. Five risk weights (0, 10, 20, 50, and 100 per cent)are utilized and assets are assigned to the five respective categories ofrisk assets, on the basis of their perceived relative level of risk.7

8. IV. Capital Adequacy of Islamic Banks • A primary issue with Islamic banking is that certain assets and liabilities of Islamic banks differ from those of conventional banks. The issue raises questions about the classification of Islamic banks risk-sharing funds, as capital or investments (Bank of England, 1997), and has implications for assessing their capital requirements. • The two main types of deposits in Islamic banks demand deposits and term deposits function differently from those in conventional banks. • Term deposits are invested on the basis of restricted or unrestricted profit-and-loss-sharing (PLS) basis • For example, in the U.K, Ijarah mortgages are subjected to a higher capital risk weighting of 100% (as against 50% for conventional mortgages) in accordance with the Basle Committees reference risk weight for mortgage loans on residential properties.

9. IV. Capital Adequacy of Islamic Banks It is difficult to state a precise higher capital adequacy ratio for Islamic banks, it is suggested that the assessment of an appropriate level of capital adequacy ratio for Islamic banks should be carried out on a bank-by-bank and country by- country basis. The conflict in the conceptual and practical approach to Islamic banking is due to the following factors : (i). Vulnerability of PLS transactions to agency problems; (ii). Absence of a well defined property right; (iii). Competition with conventional banks necessitates relatively less risky modes of finance; (iv). Restrictive role of investors for participatory decision-making; (v). Feasibility of PLS instruments for funding short-term projects; and (vi). Non-existence of secondary markets for trading in PLS financial Instruments.

10. V. THE ACCOUNTING AND AUDITING ORGANIZATION FOR ISLAMIC FINANCIALINSTITUTIONS (AAOIFI) STANDARDS • AAOIFI has made recommendations. • Investment accounts are not liabilities, but are used to financeassets managed by the bank as mudharib. • There are certain risks that will make an Islamic bank liable forPLS accounts, which has implications for thecapital adequacy ratio.

11. AAOIFI STANDARDS (continued) • The Committee concluded that, although the banks own capitalis not legally exposed to the risk of the assets under management, theymay be exposed to displaced commercial risk and fiduciary risk. • Displaced commercial risk arises as a result of market pressures thatlead to Islamic banks subsidizing the returns paid to investors. • Thus,Islamic banks own capital is exposed to the volatility of returns onthe assets managed on behalf of investors. Fiduciary risk arises as aresult of misconduct, negligence or breach ofcontract on the bank part (Archer, 2000).

12. AAOIFI STANDARDS (continued) • The Committee also concluded that it would not be appropriateto treat PLS investment accounts as part of the banks Tier 2 capitalin the numerator of the Capital Adequacy Ratio, especially since theywould not generally meet the Basle requirement of having maturity of at least five years. • The Committee decided that the proportion of the investment account-financed assets, to beso included, should be 50 per cent.

13. VI. Building Block Approach • Risk weightings under the Basle scheme are intended to reflect creditor default risk (Archer, 2000 and Gardener, 1991:114f.).Nevertheless, national supervisory authorities have discretion to buildin some other kinds of risk. • This notwithstanding, the requirement tomaintain 8 per cent capital adequacy ratio is not appropriate wherethe assets are not loans and the concern is not the creditworthiness ofthe borrowing party (O`Neil, 1992: 146)

14. VI. Building Block Approach (continued) • Review of Islamic Economics, Vol. 8, No. 1, 2004 63in equity trading or equity portfolio management operations, whichare at times under mudharabah, such assets should be subject tomarket risk capital requirements. This should also apply to tradingand portfolio management in commodities and real estate. However,on-balance-sheet assets held outside the trading book, such asmedium to long-term equity participations, joint ventures in the formof mushrakah and mudharabah, and denominated in a foreigncurrency are subject to both the market risk (i.e. foreign exchange)and credit risk capital requirements (Obiadullah, n.d.).

15. VI. Building Block Approach (continued) • The European Union has adopted the building-block approach,which seeks to incorporate market risks faced by banks. It involvesthe allocation of a credit institutions holdings of financialinstruments between trading book and the non-trading/banking book,on the basis of objective and consistently applied criteria. • Thetrading-book is required to be marked to market, that is, to calculatethe current market value of financial instruments on a daily basis. • Thetrading-book position is supported by separately calculatingappropriate amounts of capital cover for the various identifiable risksinherent in the holding of trading positions,

16. VI. Building Block Approach (continued) • In theory, the European Unions trading-book risks must becovered out of an institutions capital base. However, the CapitalAdequacy Directive permits the use, for this purpose only, of amodified definition of capital, which includes additional (Tier 3)items. This comprises the following: (i). an institutionÕs net trading book profits, net of charges ordividends, less net losses on its other business, provided thatthese have not already been included in the calculation of the capital base; (ii). subordinated debt having an initial maturity of over two years; (iii). the institutions illiquid assets.

17. The Bahraini Initiative • In 2002, the Bahrain Monetary Agency (BMA) took the lead in the regulation of Islamic banking by issuing the Prudential Information and Regulatory Framework for Islamic Banks. • The regulations are applicable to all Islamic banks operating in Bahrain, and cover the following areas of regulation: • Capital adequacy Ð credit and market risks; • Asset quality, including monitoring of large exposures and related party exposures; • Management of investment accounts Ð both restricted and unrestricted and on-and off-balance-sheet; • Liquidity management Ð on- balance-sheet and separate funds pertaining to restricted investment accounts; and • Earnings quality.

18. THE OBJECTIVE OF THE REGULATIONS • is not only to provide a regulatory framework, but also to access information from the returns that banks have to fill out. • Under the regulations, the BMA sets a capital adequacy target figure of 12%, to cater for fiduciary risk and displaced commercial risk. • The regulations cater for future innovation by providing for BMA’s prior approval for the application of an appropriate risk weighting category, when Islamic banks utilize contracts that are not covered in the regulations

19. CONCLUSION • The measurement of capital adequacy is a very important element in the overall process of assessing bank’s soundness. • Capital adequacy is a vital supervisory area, as an efficient bank’s overall risk exposure may draw out important risk relationships, and a probe into a bank’s capacity to carry its current and projected risk exposures. • The BMA’s effort to tackle the use of capital adequacy for Islamic banks operating in Bahrain is laudable and ought to be emulated globally as an international standard. • There are two major developments that are likely to influence the development of a global capital adequacy standard for Islamic banks. : • The first is the welcome establishment of the Kuala Lumpur based Islamic Financial Services Board (IFSB). 2. The second development is the Basle Committee’s proposed new Capital Accord (Basle II), scheduled for implementation in the year 2007. This Accord provides a flexible structure in which banks would adopt approaches that best fit their risk profile.

20. Syukron – thank you