1. Capital Adequacy Framework for Islamic Banks
Dr. Habib Ahmed

2. 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

3. 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)

4. Background (2) Liabilities Assets 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

5. More risks need more capital (to avoid bankruptcy)
Role of Capital
Examples:
Case 1: E=10
State 0: A=100, L=90, E=10;
State 1: A=95, L=90, E=5;
State 2: A=85, L=90, E=-5; (Bankrupt)
Case 2: E=20
State 0: A=100, L=80, E=20;
State 1: A=95, L=80, E=15;
State 2: A=85, L=80, E=5
More risks need more capital (to avoid bankruptcy)

6. 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

7. 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.

8. 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.]

9. 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%

10. Capital Requirements—Example
Liabilities
Assets
Deposits/Debt ,000
Total Capital ,000
Cash ,000
Govt. Bonds ,000
Deposits at Banks ,000
Loans for Residential
Properties ,000
Loans to Private
Corporations , 000
Total ,000

11. Capital Requirements—Example (contd…)
5,000
20,000
25,000 x 0 = 0
0% Risk Weight
Cash
Govt. Bonds
5,000 x 0.2 = 1000
20% Risk Weight
Balances with Banks
10,000
10,000 x 0.5 = 5000
50% Risk Weight
Loans for Residential Properties
60,000
60,000 x 1.0 = 60,000
100% Risk Weight
Loans to Private Corporations
66,000
Total Risk Weighted Assets

12. 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%

13. 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)
Risk weighted Assets=55,000
Total Capital/Total Risk Weighted Assets=5,000/55,000=9.1%

14. 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)

15. 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.)

16. 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) [

17. 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

18. 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:
Unrated
Below BB-
BBB+ to BB-
A+ to A-
AAA to AA-
Credit Assessment
100%
150%
50%
20%
Risk Weight

19. Basel II Standards— Market Risks
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.)

20. Basel II Standards—Operational Risks
Operational Risk—three approaches
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 %

21. 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

22. IFSB Standards—Introduction
In December 2005 IFSB published
“CAPITAL ADEQUACY STANDARD FOR INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES” (71 pages)
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)

23. Typical IB Model Liability side Asset side Balance Sheet Liabilities
Deposits & Debt
Banking Portfolio
Reserves
Equity
Trading Portfolio
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)

24. Issues in Capital Adequacy for IBs
Asset side:
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

25. 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.

26. Capital Requirements— Example (1): Salam contract
Market Risk Capital Charge
Credit RW
Applicable Stage of the Contract
The Simplified Approach
15% capital charge on long position of salam exposures
Based on customer’s rating or 100% RW for unrated customer
Payment of Purchase Price by the IIFS to a Salam customer
Not Applicable
Receipt of the purchased commodity by the IIFS
The purchased commodity is sold and delivered to a buyer

27. Capital Requirements— Example (2): Operating Ijarah
Market Risk Capital Charge
Credit RW
Applicable Stage of the Contract
Non-binding PL
15% capital charge until lessee takes possession
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
Asset available for lease (prior to signing a lease contract
The residual value will be risk-weighted 100%
Total estimate value of the lease receivables shall be risk-weighted according to the lessee’s rating. 100% RW for unrated customer
Upon consigning a leasing contract and the lease rental payments are due from the lessee
15% capital charge of the carrying value of the asset
Not applicable
Maturity of the contract term and the leased asset is returned to IIFS

28. IFSB Standards Standard formula for regulatory capital Note:
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)

29. IFSB Standards-Example (1)
Liabilities
Assets
PSIA
Demand Deposits
Equity
Cash
Total Assets
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/[ ] = 5/61.5 = 8.1%

30. IFSB Standards-Example (2)
Liabilities
Assets
PSIA
Demand Deposits
Equity
Cash
Total Assets
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= 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/[ ]=5/85.5= 5.9%

31. 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

32. Thank you!