Basel II - Implications for Islamic Banking

Top 20 FREQUENT WORDS

risk 144 banks 118 islamic 103 basel 63 risks 59 financial 57 assets 54 claims 50 minimum 45 credit 43 deposits 42 requirement 38 exposure 36 supervisory 36 operational 35 equity 34 financing 33 adequacy 32 conventional 30 investment 29 management 29 unrestricted 29

DOCUMENT KEY POINTS

• section one will summarize the main concerns of the basel ii proposals and section two will examine the islamic financing modes and practices that are sensitive to these proposals while section three will focus on the expected effects of the basel ii accord on the islamic financing modes and the islamic banks practices and on the necessary adjustment in the latter to accommodate the ideas floated in the new basil proposed accord
• unlike both errico and farahbaksh who followed a dogmatic approach based on pre assuming either of two paradigms for islamic banks and unlike the theoretical approach of khan and ahmad we will proceed in looking at the islamic banks actual practices and the composition of their assets and liabilities as indicated in their balance sheets and financial reports

• a the first pillar a calculation of minimum capital requirement risks identified in basel ii although the proposed basel accord ii is only concerned with risks from the point of view of its treatment of capital adequacy it is in the interest of this paper to look at the different kinds of risk an islamic bank is normally exposed to and their respective effect on its capital adequacy

• pillar that is devoted to the calculation of minimum capital requirement did not give much attention to certain external risks especially changes in the benchmark on the ground that these kinds of risks are intrinsic to the main role of management and must be taken care of by its daily business decisions and that it is difficult to have consensus on methodologies of calculating their effect on capital adequacy besides the fact that changes in the benchmark only reflect lost opportunities rather than the actual existing contractual relationships between a financial institution and its debtors

• the standardized methodology requires individual banks to depend on external credit assessment by approved institutions in determining the risk rating of their assets and for each of the above mentioned kinds of assets the accord suggests a given weight corresponding with each such rating
• table simplified sample of risk weights assigned to ratings rating aaa to a to bbb bb to below unrated kind of asset aaato bbbbb claims on sovereigns and pse claims on multilateral dev

• these other assets include investments in equity and regulatory capital instruments issued by banks or securities fir miss for off balance sheet items the basel ii suggests a set of conversion factors that vary between and according to the nature of the item the quality of collateral and the term of the commitment
• high risk claims include claims on sovereigns public sector entities banks and securities firms rated below b claims on corporates rated below bb past due loans securitization claims that are rated between bb and bb venture capital and equity investment

• once the risk components are identified and calculated for each subclass of asset as well as for each debtor and type of exposure risk weight functions may be determined that will be applied to the different sub classes of assets in calculating the value of risk weighted assets that will be used in determining the minimum capital requirement that is necessary to meet credit risk exposure of the bank
• to be able to rely on an internal rating based approach a bank must demonstrate to its supervisor that it has a consistent rating system that is able to quantify the risk weights of its assets in accordance with the best practices and guidelines given in the accord and from time to time by the supervisory authorities

• it is the risk of faulty system people or procedures regardless of whether the fault is intentional such as fraud or theft or unintentional such as internet or electricity failure and regardless of whether the loss is caused by outsiders such as changes in regulatory policies or insiders such as inadequate or incompetent internal safely procedures

• finally the advanced measurement approach allows using internal measurement methodologies to calculate the minimum capital requirement for operational risk exposure provided the bank satisfies certain qualification criteria that assure the supervisory authority of the existence of efficient and independent operational risk management system and of its ability to fairly estimate operational risk and the capital needed to face it including the expected losses as well as the unexpected losses

• a financial collateral is allowed to reduce the credit risk exposure and consequently capital requirements if certain conditions are satisfied that include having the right to liquidate or take legal possession in a timely manner by replacing the risk weighting of the collateral for the risk weighting of the exposure subject to a floor but if the bank uses the comprehensive approach it may be able to reduce the exposure amount by the value of the collateral section
• b the second pillar a supervisory review process the stated objective of the supervisory review basel accord is two folds to ensure that banks have adequate capital to support all the risks in their business and to encourage banks to develop and use better risk management techniques in monitoring and managing their risks section

• these issues include interest rate risk in the banking book certain kinds of operational risks conducting and assessment the results of stress tests exacting the definition of default assessment of the residual risk and credit concentration risk capital treatment for certain specific securitization exposures keeping up with market innovations and changes in both the financial arena and the it arena etc
• keeping in mind that a capital increase may not be the ultimate solution to a bank troubles the supervisors should be able to take necessary action to enhance or even enforce a restructuring of a bank s risk management policy and strategy to reshuffle its risk managerial entities and capabilities and to re consider its capital adequacy assessment

• they include the scope of application for consolidated statements capital structure including the amount of tier capital the total amount of tier and tier capital and the total eligible capital determinants of capital adequacy risk exposure and assessment for each separate risk area e
• the qualitative and quantitative disclosure requirements are explained in tables through in sections a of the committee s proposals

• it is important to remember that the basel ii proposals restrict their concern to the effect of risks on capital adequacy rather than discussing risk management because the latter is a matter of management attitudes strategies and policies that except to the extent they may lead to unsound capital position vis a vis claims on the banks should not be a subject of concern to the macro monetary management supervision whose interests are focused on the stability of the system rather than on the solvency of a specific financial intermediary

• according to this standard ownership transfer is effected at the end of the lease period by either giving the leased asset as a gift selling it to the lessee for a nominal or non nominal price selling it during the lease contract for a price that is equal to the face value of the remainder of the rental installments which is unrealistic because it does not take into consideration the effect of maturity on value and if it does it becomes covered under sale for nonnominal price or gradual sale of consecutive portions along with rental payments section of standard

• in financial lease the commitment of the lessee is binding regardless of what happens to the leased asset since the lessee is the one who deals with insurance while in the ending with ownership ijarah the lessor remains responsible for making the asset available to the lessee therefore the former remains responsible for the asset and its insurance though its premiums are implicitly or explicitly charged to the lessee it is the lessor who in principle deals with insurance

• non debt crating islamic financial modes financing modes of mudarabah and musharakah do not crate debt because the beneficiaries of these modes of financing do not stand liable for the principal of or any return on this financing unless when a loss occurs as a result of negligence or transgression on their part

• assets structure of islamic banks a closer look at a the financial statements of a few islamic banks aside from the theoretical proposals of the aaoifi s standard provides us with an a practicable picture of how the financial statements disclose their different assets in a manner that allows the supervising authority and others to make their judgment about the sufficiency of information to measure capital adequacy and to look into the fulfillment of the basel ii disclosure requirements
• f investment in real estates f investment in leased assets six banks showed separately claims from foreign commodities murabahah some banks also sowed separately claims from istisna and salam there is no unified standard of aggregation in assets even in banks that are under the same supervisory authority as our sample has three banks under the bahrain monetary agency one of them is an off shore bank

• a c claims on domestic businesses and industries a c claims on domestic individuals and a c claims on domestic contractors to wrap up this sub section one may fairly conclude that although islamic banks do not have a unified standard for presenting their financial statements most of them do not deviate much from the theoretical standard no

• section three potential effects of the basel ii accord on the islamic financing modes and the islamic banks practices the underlying assumption of the basel ii proposals for the calculation of capital adequacy to face potential risks is that the counterpart of the asset side in the statement of financial position balance sheet consists of liabilities and equity only
• unrestricted investment deposits consist of funds deposited in the i b for the investment purposes whereby the bank is given full freedom discretion and authority to invest in any way project and manner it deems appropriate and to mix them with its own funds equity and with other funds the bank may have authority on their use ie liabilities including deposits in current accounts

• does the presence of restricted and unrestricted deposits matter for the calculation of capital adequacy what is the effect of the presence of unrestricted investment deposits in the a credit side of the statement of financial position and of a separate statement for restricted deposits on the objectives of the basel ii proposals to answer this question we need to look from two angles
• additionally we need to explore the potential or expected position of the supervisory authorities in regard to the risks to which both the restricted and the unrestricted investment deposits are exposed to would instability in these two kinds of deposits have a negative effect on the solvency of a given bank and or the banking industry in general and if not would the supervisory authority be indifferent to such instability

• consequently while we do not disagree with the basel ii committee on the use of gross income as a proxy of operational risk exposure and on the use of either the basic indicator approach the standardized approach or the advanced management approach to measure the operational risk exposure the outcome of this calculation for an islamic bank must be a total equity requirement that consists of both owners capital and the equity of the unrestricted deposits holders
• operational risks in islamic banks qualitatively speaking operational risks are the same in islamic banks as they exist in conventional banks that operate in the same business environment

• this discretionary use must impose a counterpart burden on the i b otherwise the responsibility would not mach liability the quantitative effect of these elements should be estimated and incorporated into the parameters used in the calculation of the minimum capital requirement in islamic bank regardless of which approach a given i b used in estimating the credit risk weighted assets
• would any supervisory authority like to take a similar position especially that such a behavior has a tremendous impact on the stability of deposits and on the islamic banking industry at large i argue that the supervisory authority has a moral and economic responsibility to impose such kinds of restrictions on the behavior of the senior management of islamic banks

• the supervisory authority has a duty similar to that envisioned by the basel ii proposal to assure capital adequacy in islamic banks at a level that matches this kind of trading book risk exposure that is several times higher than that the trading book risk encountered in conventional banks without loosing the principle of including the owners of unrestricted deposits in shouldering this risk up to a fair limit that reflects the essence of the this may seem surprising to many including those who believe in the two tier mudarabah and those who think that the ibs involvement in murabahah international murabahah and international tawarruq

• in islamic banks equity must be interpreted to include the equity of shareholders and the equity of the owners of unrestricted deposits because the latter carry their share of the risk of losses by virtue of the mudarabah contract
• trading book risks in their literal sense rarely exist in islamic banks but quasi trading book risks are much higher in i bs than in the conventional banks

Please note, This is an auto generated summary based on sentances position in the document and other factors

DOCUMENT WORD ANALYSIS

Main Category

AlHuda Material\islamic banking

KeyWords

islamic risk murabaha minimum iifs NA customers financing customer banking profit credit maximum shariah underlying limit service corporate required mode

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DOCUMENT REFERENCES

Number of Pages

27

Published Date

2007-03-09 18:31:21

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