As of the start of this year, a large number of banks worldwide are required to calculate regulatory capital under the new capital adequacy rules generally referred to as Basel II. Although initially designed for large, internationally active banks in the G10 countries, almost every financial regulator in the world is planning to introduce the new framework in some shape or form over the next couple of years. In addition, they intend to apply the rules to all the banks under their supervision, whether they are big or small, conventional or Islamic.
The impact on Islamic banks is partly the same, and partly different. Due to a combination of the banks' size, the structure of Islamic transactions and the applicable approaches, the capital charge for an Islamic bank is likely to be higher, which will in turn have an impact on the price of the transactions.
Determining Capital Adequacy
Capital adequacy is a measure of the financial strength of a bank or securities firm, usually expressed as a ratio of its capital to its assets. Basically, banks are required to hold a minimum level of capital to prevent overlending and to ensure that the bank has sufficient funds in case any of its counterparties default without endangering depositors, the banking system or the economy.
The current capital adequacy rules came into effect in 1988 and are generally known as Basel I. Within this framework, only credit risk and market risk have an impact on the level of regulatory capital. Assets are assigned a risk weight as illustrated in the table below.
Risk Weighted Assets (RWA) are determined by multiplying the outstanding exposures per counterparty by the risk weight that applies to the type of counterparty. Risk mitigation such as netting and pledged deposits can be applied to reduce RWA as long as a set of predefined conditions are met. Regulatory capital is then determined as the aggregate of all RWAs multiplied by 8 percent.
One of the main issues with the current capital accord lies in the fact that there is no distinction between high- and low-quality borrowers. This becomes immediately apparent from the examples below.
No Distinction in Borrower Quality
National Grid Group, one of the world's largest utilities companies, and Enron are both classified as "corporates." Their exposures are risk weighted at 100 percent and this applied even when it started to became evident that Enron had a much lower credit quality. For every 100 of credit extended to each of these borrowers, the bank has to maintain 100 * 100% * 8% = 8 in capital.
The National Bank for Foreign Economic Activity of the Republic of Uzbekistan and HSBC are both classified as "banks," which means their exposures attract a 20 percent risk weight. This implies that for every 100 of credit extended to them, the bank only has to maintain 100 * 20% * 8% = 1.60 in capital.
In both cases, the chances of either party defaulting differ significantly due to their credit quality. However, the amount of capital required on their exposure remains the same.
There are more disadvantages to the current capital accord, such as the fact that there is no distinction between long and short-term loans and the limited use of risk-mitigating techniques, which the Basel Committee attempted to address in the Basel II framework.
Fixing Problems
The intention of Basel II is to address the shortcomings that are inherent in the Basel I accord. For starters, it introduces counterparty grading to overcome the fact that there is currently no distinction between low and high-quality borrowers.
Basel II is organised around three mutually reinforcing pillars:
Pillar 1: Minimum Capital Requirements
The new framework maintains both the current definition of capital and the minimum requirement of 8 percent of capital to RWA. There is an increased emphasis on credit risk measurement and mitigation techniques. Market risk, which was previously taken into consideration in the overall RWA calculation, is now segregated from credit risk. A capital charge is introduced for operational risk. The Basel II framework does not introduce any changes to the calculation of capital for market risk beyond the specification of the 1996 market risk amendment to Basel I.
For both the credit and operational risk components, three different approaches are available, each with a different level of sophistication.
Available Approaches for Credit Risk
Credit risk is defined as the risk that a counterparty will default on one or more of his payments. Three approaches can be used to determine the required capital:
Standardised Approach
The standardised approach is roughly the same as the current Basel I approach. In addition to the standard risk weights currently available, clients need to be graded by an External Credit Assessment Institution (ECAI). The rating of the counterparty is now incorporated into the overall risk weighting
Foundation Internal Ratings Based Approach (FIRB)
Banks do not rely on ECAIs for their ratings, but determine the probability of default (PD) of their borrowers using an internally built model. Loss given default (LGD) and exposure at default (EAD) are determined based on supervisory rules defined in the Accord.
Advanced Internal Ratings Based (AIRB)
Not only the PD, but also LGD and EAD are determined based on internally built models.
Available Approaches for Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This includes legal risk, but excludes strategic and reputational risk. Similar to the calculation of the minimum capital requirements for credit risk, three methodologies are available for the calculation of operational risk capital charges:
Basic Indicator Approach
Capital charge is calculated as a fixed percentage (15 percent) of average gross income over the previous three years. The percentage is determined by the regulator.
Standardised Approach
The banks' activities are divided into eight business lines and the capital charge is calculated per business line as a percentage of gross income. The percentages differ according to the business line and are set by the regulators
Advanced Measurement Approach (AMA)
Under the AMA approach, banks apply their own internally developed model which incorporates quantitative and qualitative criteria such as internal loss data, key risk indicators, scenario analysis and self-assessment.
Pillar 2: Supervisory Review
Supervisors are required to ensure that each bank under its supervision has sound internal processes in place to assess the adequacy of its capital. Typically they employ an internal capital adequacy assessment process (ICAAP) which is prepared by banks and reviewed by supervisors. In addition, specific review visits are part of this process. The supervisor can request additional capital for any issues not covered under Pillar I, such as interest rate risk in the banking book and concentration risk.
Pillar 3: Market Discipline
The majority of disclosures are recommended and not mandatory. The intention is to reduce potential overlap with other disclosure standards such as IFRS and IAS. As a result, additional disclosures are only mandatory in relation to the implementation of particular methodologies or instruments.
Generally, it is expected that large banks with sophisticated risk management systems will benefit from the new regulation and see their capital reduced. However, this also strongly depends on overall counterparty credit quality and robustness of internal control processes and procedures. For the industry as a whole, the required capital is expected to remain as is, or potentially even increase.
Impact on Islamic Banks
The impact of the changed regulation on banks in general is quite significant. Substantial investments have been, and continue to be, made in enhanced technology. To date, the exact impact on regulatory capital is still unknown.
The impact on Islamic banks is largely the same as for the conventional banking industry. However, there are a few issues specific to Islamic banks.
Balance Sheet Size
Although the Islamic financial industry has grown substantial in the past years, the size of individual banks is typically not large enough to justify the investments required for the advanced approaches.
Application of Capital Adequacy Standards - The Islamic Financial Services Board (IFSB) has published a standard for capital adequacy for Islamic financial institutions which largely follows the principles of the Basel II accord. The IFSB standard itself only defines the standardised rule, although it is implied that more advanced approaches can be applied, provided that approval is obtained from local supervisors. However, even where internal modelling approaches are allowed, the question arises as to whether sufficient loss data is available to ensure robustness of the model.
The IFSB standards are not implemented globally. In the UK, for instance, the governance for capital adequacy is part of the Financial Services Authority (FSA) Handbook, which applies across all banks and financial institutions. No specific provisions are made for the characteristics of Islamic products. However, the treatment of Islamic transactions for capital adequacy under the prudential regulation is similar to what is described by the IFSB.
Transaction Types
The major drawback of the Basel II accord is a direct result of transaction structures. The Basel Committee of Banking Supervision (BCBS) takes the stand that banks should not hold significant equity positions in companies that are also their counterparties. The underlying principle is that the risk a bank takes increases when ownership and the provision of debt funding are in the same hands. Profit-sharing structures in Islamic finance such as Mudaraba and Musharaka are not held with the intent of trading and are therefore, from a risk perspective, similar to holding equity. Under both the IFSB and the Basel II standards on capital adequacy, these investments are calculated using the simple risk weight method and attract a 400 percent risk weight.
Ever Evolving
Given the strong growth in Islamic finance, balance sheet size and lack of loss data is not expected to remain an issue for many banks in the long run. However, ensuring the use of robust counterparty ratings will have a positive impact on the risk management process and the level of capital required.
The structure of Mudaraba and Musharaka transactions are not capital efficient, and will therefore become more expensive from the bank's perspective. In the development of new transaction types and when advising clients, the cost of capital will need to be a factor to be considered. Whether the client's interest can be served equally well with a different structure is one of the questions that will need to be addressed as part of the advisory function of the bank. Although it could be argued that due to the stronger link between bank and counterparty, the chances of default will reduce, the counterargument presented by the BCBS and the resulting higher capital charge for equity products is equally valid.
Looking at longer-term developments, the sharing of a loss experience database such as is done via consortia in Europe and North America for conventional banks needs to be considered carefully. Although data sharing is a sensitive point and will need to be managed carefully, it will allow the Islamic financial industry to build advanced risk measurement models that would otherwise remain out of reach. Once these models reach maturity, they can be used to enhance the global regulatory environment.
Dr. Natalie Schoon, CFA, has been working for international financial organisations since 1989 and has extensive experience in the field of treasury, investment banking and risk management. She holds a PhD in residual income models and the valuation of conventional and Islamic banks and an MBA in banking and finance and is a CFA charterholder. Natalie first came across Islamic finance in the mid-1990s while working in Dubai and Bahrain for a large international bank. She is currently based in London, where she is working as a senior consultant in finance and risk management.
By Dr. Natalie Schoon, CFA
Business Islamica 2007
