Basel III in support of the Islamic banking principal

What is wrong with GCC sukuk markets?
December 23, 2010
Tears of Gaza
December 24, 2010
What is wrong with GCC sukuk markets?
December 23, 2010
Tears of Gaza
December 24, 2010
Show all

Basel III in support of the Islamic banking principal

Basel III in support of the Islamic banking principal

Dr Aly Khorshid Available at: http://www.english.globalarabnetwork.com/201012228432/Finance/basel-iii-in-support-of-the-islamic-banking-principal.html

The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative, and securitization activities to be introduced at the end of 2011.

Islamic banks are among the best capitalized banks in the world, and historically comply with inflexible standards of capitalization, Islamic Bank for capital requirements means that local banks already exceed norms set by the Bank for International Settlements (BIS) as part of the Basel III accord.

Islamic Bank already has stricter capital requirements than what is proposed in Basel III. With the Islamic banks being amongst the best capitalized on a global scale, they are on the safe side compared to their European or US counterparts, Tier 1 and total capital requirements currently stand at 8 per cent and 12 per cent, respectively, which are already higher than the target 2019 ratios set by Basel III.

The BIS reported this week that it has reached an agreement to increase key capital ratios for banks. The minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2 to 4.5 per cent after the application of stricter adjustments. This will be phased in by January 1, 2015. The total Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4 to 6 per cent over the same period. There will also be a ‘buffer requirement’ of 2.5 per cent that can be drawn down to the 4.5 per cent minimum requirement during times of stress. This effectively will raise common equity requirements to 7 per cent.

If a bank draws below the 7 per cent common equity requirement, including the buffer, distribution of earnings must be curtailed until the 7 per cent level is recovered. These restrictions would apply to dividends and executive compensation, including bonuses.

These changes are intended to reinforce banks’ capacity to absorb future potential losses. The transition period for the world’s banks to comply with these rules has been extended to January 2019 vs. the end-2012 deadline set by the regulators last year. This news was positively welcomed by the investor community as evident through the climb in banks share prices in Europe and Asia.

President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, said that “the agreements reached today are a fundamental strengthening of global capital standards.” He added that “their contribution to long term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery. The Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, added that “the combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth.”

Increased capital requirements

Under the agreements, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments.

This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macro prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well-integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes. The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements. Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.

The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards. These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The transitional arrangements, which are summarized in Annex 2, include:

· National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

§ 3.5% common equity/RWAs;

§ 4.5% Tier 1 capital/RWAs, and

§ 8.0% total capital/RWAs.

· The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015. On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%. On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements. The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.

· The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.

· In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

· The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

· Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

· Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

· Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point:

§ They are issued by a non-joint stock company

§ They are treated as equity under the prevailing accounting standards; and

§ They receive unlimited recognition as part of Tier 1 capital under current national banking law.

· Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

Phase-in arrangements for the leverage ratio, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration. 
After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018. The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary. 


The Basel Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. 


The Group of Central Bank Governors and Heads of Supervision is the governing body of the Basel Committee and is comprised of central bank governors and (non-central bank) heads of supervision from member countries. The Committee’s Secretariat is based at the Bank for International Settlements in Basel, Switzerland.

The affect Basel III on Emerging Market

Basel III staggers towards the finishing line at group of 20 leading economies meeting in Seoul, it has become clear that the needs of emerging markets have been ignored. 2004’s Basel II proved fiendishly difficult to apply in conditions where even large corporations lack credit ratings; where the data to build credit-scoring systems barely exists; and where there are few institutional investors who might actually read public disclosures. Far from fixing this, Basel III makes it even worse.

Much of the agreement, of course, is aimed at advanced economy banks. Rules for their investment portfolios are irrelevant to banks that stick just to deposits and loans. Even redefinitions of capital will have little impact. Emerging market bank capital often comprises equity, reserves, and not much else, while tier 1 capital ratios are already high. Bans on financial instruments might dissuade investment bankers from peddling them in emerging markets but little else.

That said, formidable technical challenges would make it hard to implement those areas where the reforms are relevant and badly needed. Basel has previously neglected the issue of liquidity, but its proposals involve sophisticated new stress testing that goes far beyond the risk management capabilities of most emerging market banks. Risk management systems also require regulators who can use judgment and discretion. But exercising discretion in turn requires things not so readily available to emerging market regulators: independence, immunity from law suits and willingness to challenge the well connected.

Even when these difficulties are put aside, Basel III poses two fundamental challenges for emerging markets.

The first concerns deadlines. After the banking industry stoked fears that Basel III’s requirement to raise more capital could choke off nascent economic recovery, an Augustinian compromise was reached: “Lord, make my banks well capitalized but not yet.” As a result, implementation is now stretched until the end of this decade.

Yet emerging markets need to operate on a different timetable. They have rebounded from last year’s global recession and, in some cases, are experiencing booms that monetary policy, still effectively set in Washington DC, is not constraining. Increasing capital and liquidity standards now, under the cover of international requirements, would have had beneficial counter-cyclical effects. However, Basel III’s transition period means that no emerging economy is likely to want to be the first mover. Bankers in developing countries will argue with some justification that they should not be disadvantaged relative to competitors in advanced economies.

The second challenge is whether it makes sense for emerging market banks to be more highly capitalized and liquid than those in wealthier countries. In the past it was an article of faith that emerging market banks needed bigger capital and liquidity buffers, because of their more volatile operating environment. But, as the tier 1 ratio rises, should emerging economies ratchet up their own requirements just to maintain an emerging market premium?

The question matters because emerging and advanced economies have different risk appetites. For the latter, the goal is to avoid a repeat of the crisis. By contrast, for emerging markets the objective is growth to meet the needs of rapidly expanding populations. Another turn to the regulatory ratchet would make their banks stronger and more stable, but at the risk of lowering growth.

The Basel committee needs to offer an alternative standard tailored to the needs of emerging markets. The elements of such a “Basel III-lite” are not hard to find: a simpler measure of a bank’s leverage based on a ratio of total assets relative to core capital; rules to ensure that risks cannot be hidden off balance sheet or in subsidiaries; simpler liquidity rules; and clear guidelines to ensure that bad loans are promptly written down in value. Even better, it might be possible to implement such a plan more quickly than the decade we must wait for full compliance with Basel III.

Basel III is needed as first step for Global financial regulation

Two years to the week after Lehman Brothers went down, international regulators approved a series of measures aimed at preventing a repeat of the 2008 financial crisis. On 12 September, central bankers from 27 nations met at the offices of the Bank for International Settlements in Basel, Switzerland, to forge new guidelines on the amount of capital (basically equity) that banks need to hold against the assets on their balance sheet. Many think that the Basel Capital Accord (or “Basel III”, as it’s known) is a whitewash, a sop to placate whining politicians.

Bank stocks rose to their highest level in four months as news emerged of the weaker-than-expected regulation. Lloyds TSB and Royal Bank of Scotland shares jumped 3 per cent in relief. The local Swiss regulator immediately stated that it would insist on more stringent rules for its own banks. The UK and US will likely follow suit. Paul Myners, the former City minister, gave the measures a grudging 3 out of 10. The Nobel Prize-winning economist Joseph Stiglitz lambasted the timetable of the accord as “unconscionable”. At first glance, you can see their point. All of the major UK and US banks will pass the requirements with flying colours: of the 62 US banks with over $10bn in assets, 61 pass. The once-shaky Lloyds and RBS will make the grade with ease. Even the banks that are struggling (mainly German and Spanish) have until 2019 to meet the standards. As with the stress tests carried out earlier in the year, Basel III seems designed to help bolster confidence in the sector, rather than force the large-scale reforms many had hoped for.

Too big to fail

Time for some painful details. Basel III states that banks should now hold 4.5 per cent of “core” Tier 1 capital (the best kind) against their “risk-weighted” assets. This more than doubles the previous 2 per cent limit. Furthermore, an extra 2.5 per cent of capital will be held as a buffer against the kind of shocks we experienced two years ago. A final capital charge will be applied to systemically important banks – the “too big to fail/too big to save” institutions such as Barclays and Citigroup.

The most important element of the regulation, however, is the liquidity coverage ratio, which requires banks to have sufficient easily liquidated assets on hand to cover a month’s worth of outgoings. It is this final rule that might help prevent another Lehman Brothers, because it was liquidity that finally brought down the US giant.

However, one important issue remains unaddressed by the accord: the definition of “risk-weighted assets”. Much of the criticism of Basel III has been directed at the numerator in the capital adequacy calculation – what can be included as Tier 1 capital. But the danger lies with the denominator. Central to the Basel III regulation is allowing banks (with the help of the rating agencies) to decide the riskiness of their asset base.
 Banks are judged – as is any corporation – by their return on equity. With more (and better- quality) equity having to be held against risk-weighted assets, the onus will fall on the bankers to find ways of reducing the perceived riskiness of their asset base. One way they have done this in the past? Taking sub-prime loans – highly risky securities – and packaging them into AAA-rated “collateralised debt obligations” that were supposedly close to risk-free. And we all know how that ended.

So is Basel III just window-dressing, as many have claimed? No. The Basel Committee on Banking Supervision has already stated that the current standards are merely the first wave. There will be further tweaks to address the “too big to fail” problem and, one hopes, some definitive guidance on the calculation of risk-weighted assets.

The requirements, though less than some hoped for, are nonetheless an improvement on what went before. Some estimate that German banks alone will have to raise €75bn of new capital to meet the tests – a cloud over the otherwise sunny landscape of the German economy.

Shock absorbers

As for the timescale, while nine years may seem far too long to fast-living City types, it makes sense to give banks time to recover from the financial crisis. Imposing constraints upon their ability to make loans in the current market only risks exacerbating the downturn. Anyway, it is unlikely that there will be another crash in the near term. With the scars so fresh, the risk is rather that banks will continue to hoard capital and prolong the slump.

More important, we now have a regulatory framework in place. No matter that the laws don’t come into effect for almost a decade: banks are being judged against the rules from today. This is why Deutsche Bank raised almost €13bn of new equity the day the rules were announced. The cash will partly be used to buy a stake in its rival, Postbank, but Deutsche Bank also wanted to send a message to the markets by upping its capital ratios. It is distancing itself from its weaker German peers and positioning itself alongside the likes of HSBC and JPMorgan. It is likely that banks will view membership of the “too big to fail” club as a boon, despite the tougher capital requirements.

What makes Basel III a dramatic development in financial history is that the Americans are on board. The US largely ignored the requirements of Basel II, preferring to allow the invisible hand of the market to regulate its banks. That the Americans have embraced Basel III gives it the credibility and momentum that previous standards lacked. This is the first time we have seen truly global banking regulation in action. It’s a critical step towards building banks that can withstand the kind of shocks that were so devastating in 2008.

Islamic Banks comply with Basel III

Islamic banks are among the best capitalized in the world, and historically stringent standards set , Islamic Bank for capital requirements means that local banks already surpass norms set by the Bank for International Settlements (BIS) as part of the Basel III accord, which has a 2019 deadline.

Islamic Bank already has stricter capital requirements than what is proposed in Basel III.

With the Islamic banks being amongst the best capitalized on a global scale, they are on the safe side compared to their European or US counterparts, Tier 1 and total capital requirements currently stand at 8 per cent and 12 per cent, respectively, which are already higher than the target 2019 ratios set by Basel III (of 6 per cent and 8 per cent, respectively).”

The BIS reported this week that it has reached an agreement to increase key capital ratios for banks. The minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2 to 4.5 per cent after the application of stricter adjustments.

This will be phased in by January 1, 2015. The total Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4 to 6 per cent over the same period. There will also be a ‘buffer requirement’ of 2.5 per cent that can be drawn down to the 4.5 per cent minimum requirement during times of stress. This effectively will raise common equity requirements to 7 per cent.

If a bank draws below the 7 per cent common equity requirement, including the buffer, distribution of earnings must be curtailed until the 7 per cent level is recovered. These restrictions would apply to dividends and executive compensation, including bonuses.

These changes are intended to reinforce banks’ capacity to absorb future potential losses. The transition period for the world’s banks to comply with these rules has been extended to January 2019 vs. the end-2012 deadline set by the regulators last year. This news was positively welcomed by the investor community as evident through the climb in banks share prices in Europe and Asia.

It appears that while actual implementation won’t start until 2013, the accords will not be fully implemented until 2018.

At this point we believe it is too early to assess the full consequences of these new regulation changes especially that Islamic banks have been complying with Basel II.

“However, until further analysis is made, we believe local banks could elect to conserve capital through constrained dividend payout,” they said.

Saudi Banks comply with Basel III

Saudi banks maintain a comfortable position, adequately fulfilling even the enhanced capital requirements that have been put forward by Basel Committee, Global Investment Research has said in a new report.

The oversight body of the Basel Committee on Banking Supervision in its meeting on September 12, 2010 announced the strengthening of existing capital requirements. The package will increase core Tier 1 capital ratio of 2 per cent (under Basel II) to 4.5 per cent (under Basel III) till January 1,

2015, and will also be supplemented by an additional capital conservation buffer of 2.5 per cent till January 1, 2019.

This enhances the total common equity requirements from 2 to 7 per cent by 2019. The minimum Tier 1 capital ratio will also rise from 4 to 6 per cent, whereas the difference between the total capital requirement of 8 per cent and the Tier 1 requirement can be met by Tier 2 capital.

Such capital reforms are believed to enhance the banks’ capability to better endure the periods of economic and financial stress, leading to improved long term financial stability and growth.

The Global report says that the Saudi banks’ Tier 1 capital ratio (above 10 per cent) during 2009 & H1 2010 remains well above the minimum requirement of 4 per cent under Basel II and 6 per cent under Basel III. “While the banks globally took up the challenges of coping with various financial issues

(including recapitalising of balances sheets), the Saudi banks largely confident of their strong fundamentals do not fear from any severe financial system issues,” the report states.

“Even in 2008, which saw the eruption of severe financial fears, the Saudi banks kept their head high with Tier 1 capital ratio above 8 per cent adequately meeting the requirements,” it adds.

The Global report quotes recent comments by IMF as encouraging. “The [Saudi] central bank’s operations were directed toward shoring up confidence in the Saudi banking system and stimulating credit growth. The banking system continued to show resilience by weathering the crisis.”

Global analysts believe that driven by the Kingdom’s economic growth potential, low credit penetration level, and domestic demand fundamentals, the Saudi banking system holds significant long-term growth potential.

The research firm estimates Saudi banks to experience modest asset and loan growth of 4 and 6 per cent, respectively, in 2010 that could reach double digit in 2011.

Banking on Trade Finance

As the largest market for Islamic finance, with assets growing over 30% a year, the scenario is attractive for Islamic wholesale, or commercial banking. CAMILLE KLASS looks at trends in the market and how these banks are priming themselves to gain a larger chunk of the market. 

With economies around the world starting to experience some form of recovery from the recent debilitating crisis and signs that global trade is picking up, trade financing is expected to flourish again, helping to drive growth further in the Islamic wholesale banking sector.

The crisis, which caused trade to dip and credit to tighten, impacted Islamic wholesale trade and finance activities even though banks engaged in Islamic wholesale activities have enjoyed growth of around 30% annually, according to estimates by international management consulting firm Oliver Wyman.

“My view is that trade and term finance will be the one(s) to watch in terms of growth in the Islamic wholesale banking space,” said Musa Abdul Malek, executive director and CEO of HSBC Amanah in Malaysia. Trade, together with capital expansion or replacement, will be the key drivers of the positive growth that HSBC Amanah expects for wholesale banking, he added.

Sharing his view, Jacques Tripon, CEO of BNP Paribas Najmah in Bahrain, said: “Trade is going to be a major driver in the world and BNP Paribas wants to develop its trade business more. We have always been a strong player in trade finance and want to emphasize it and Islamic banking as part of it.”

The volume of world trade, which contracted by around 12.2% last year, is expected to rise by around 9.5% this year, according to estimates from the World Trade Organization. Last year, the value of world merchandise exports fell 23% to $12.15 trillion.

“Due to the recovering market conditions and (a) lift in international trade volumes, related products will see uplift in demand including trade products and term finance for capital expenditure,” HSBC Amanah’s Musa said. “These are both linked to treasury products for risk profile enhancement.”

Islamic trade finance products include letters of credit, trust receipts, accepted bills, export credit financing, working capital financing as well as bank and shipping guarantees.

BNP Paribas Najmah’s Tripon said the bank is “developing a trade financing offer that comprises LC import financing, export bill discounting and forfaiting to boost trade finance.”

BNP Paribas and HSBC aren’t the only banks looking to ramp up their business in trade finance. Standard Chartered Saadiq, the Islamic banking arm of Standard Chartered Bank, and CIMB Islamic are going in that direction, too. “We are looking at building up our Islamic trade finance offerings, as well as Islamic cash management services,” said Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank in Malaysia.

At Standard Chartered Saadiq, which has experienced growth of between 70% and 80% for both consumer and wholesale businesses since it began its Islamic operations in Malaysia in 1993 and in the UAE, Pakistan and Bangladesh since 2003, head of product development Ghazanfar Naqvi said the bank is aiming to grow its trade business and customer base “at a faster pace.”

Together with trade finance products, bankers say wholesale clients will need hedging products, too, with the recovery in international trade. “As global trade picks up, trade finance and financing needs will rise again and hedging solutions (will) as well,” said Naqvi.

Bankers note that the need for hedging solutions is in line with a key trend — an increasing interest in Shariah compliant derivative products, adding that there is a real need in the market for risk management tools to mitigate currency, market and investment risks.

“The single most important trend in the Islamic wholesale banking market that is worth noting is the development of Islamic derivatives activities,” said Badlisyah. “As the industry grows, many of our wholesale banking customers need to have the ability to manage their risks effectively and efficiently. Islamic derivatives provide customers with a way to better manage these risks.”
Islamic hedging tools mainly consist of profit rate swaps, currency swaps, equity derivatives and arbun. Arbun is similar to an option in the conventional banking sphere in that it is a contract where a buyer puts a downpayment on a purchase for a later date and can choose not to go through with the transaction by forfeiting the downpayment.

Compared to the range and sophistication of hedging instruments available to clients in the conventional banking market, Islamic hedging instruments have been thin on the ground owing to divided opinions among Shariah scholars on whether they constitute speculation — a form of gambling, which is prohibited under Islamic law. Bankers say the lack of a wide range of derivatives products for hedging puts Islamic finance clients at a disadvantage when it comes to risk protection compared to conventional finance clients.

“If the Islamic finance industry wants to play a bigger role, then it needs the same tools as in conventional finance, because Islamic finance abides by the same regulations of central banks, and (international standards such as) Basel II, and Basel III in the future,” said BNP Paribas Najmah’s Tripon. “Otherwise, (the industry) is at a disadvantage.”

Citing the numerous projects in the GCC region which require financing of between 15 and 20 years, Tripon said it has been “impossible for Islamic banks to be very active in this area, the reason being the mismatch in their balance sheet.”

Bankers point to the recently introduced Tahawwut Master Agreement, created jointly by the International Islamic Financial Market and the International Swaps and Derivatives Association, as a significant milestone for the industry as it provides the industry with a framework for entering into hedging arrangements. “It’s an excellent initiative, but it doesn’t mean it will be accepted by all Shariah boards,” Tripon said. ”But it does give us more potential since the Tahawwut agreement implies less risk consumption.”

With its superior growth, Islamic wholesale banking is likely to attract increasing numbers of new entrants, especially as it develops and starts to move into the mainstream, making it imperative for existing players to devise effective strategies to grow their businesses. Deutsche Bank, which had already been involved in Islamic finance through its London, Middle East and Malaysian offices before it set up its Islamic banking branch in Malaysia to serve the rest of Asia, received an Islamic banking license from Bank Negara Malaysia in March. The bank is drawing on its success with conventional products to introduce its Islamic capabilities, expand its client base and solidify further its “global presence in Islamic products and services.”

The strategy banks seem to have in common is a focus on meeting and exceeding client expectations, providing a complete Islamic product range and ensuring that solutions are customized to clients’ needs. “As a bank we always make an effort to understand customer requirements, provide a whole range of solutions,” said Standard Chartered Saadiq’s Naqvi.

“We’ll continue to provide structured solutions, but these aren’t required on a daily basis,” he added. “We want to grow our normal financing solutions for foreign exchange, trade, financing — the kind of normal products customers need to employ to run their business because that’s where we think the real growth will come from.”

CIMB Islamic is also making sure it has its bases covered. “Our policy is to ensure that for every conventional wholesale banking product available in the market, we have an equivalent Islamic wholesale banking product solution for our customers where possible,” said CEO Badlisyah. “We develop all our products in-house, including our Islamic structured products, and we do and can tailor products for other banks and institutions. Where needed, we enter into joint ventures to provide certain services such as fund management.”

Well-known internationally for its leadership in the derivatives business, BNP Paribas is focusing on fixed income — profit rate swaps and currency swaps — for the year to come, said Bahrain-based Tripon. In terms of HSBC Amanah’s strategy for continued growth, Musa said: “The first port of call is to ensure that the customer experience is right for Islamic wholesale banking products and services. Conventional banking as we know it has been universally established for a long time, so there is a lot of ground to make up in Islamic banking to ensure that the product, service and ultimately customer experience is comparable,” he added.

His point strikes at the heart of an issue central to the Islamic finance market — the difficulty in penetrating markets that are used to conventional finance and ensuring that Islamic finance is a viable alternative in terms of cost, product features and processes. “The perception that Islamic finance solutions add more processes compared to conventional solutions needs to be managed and understood,” Standard Chartered Saadiq’s Naqvi said. “The process to give comfort to customers that it won’t disrupt the businesses activities is difficult but rewarding.”

In order to get the target market to accept Islamic solutions, countries involved in Islamic finance, excluding Malaysia, need to create an enabling legislative, regulatory, legal and Shariah governance framework, said CIMB Islamic’s Badlisyah. “Right now, it’s at a stage where we are in the education mode,” said Naqvi of Standard Chartered Saadiq. “Education and awareness are still a challenge.”

“Further client education efforts, particularly in the newer markets, would be helpful,” said Alhami Mohd Abdan, head of international finance and capital market at OCBC Al-Amin in Malaysia. “But in Malaysia, the market has grown to a certain level of maturity that Islamic finance is not so strange to a large number of clients because of the good examples set by the government benchmark issuances and Fortune 500 names such as Petronas, GE and other blue chip issuers both domestically and internationally.”

From a product perspective, “there are various factors that need to be ironed out with product developments” as “the market is growing and is still going through a rapid learning curve,” said Alhami. Certainty that an Islamic financial product or transaction is devoid of ambiguity, inconsistency and the risk of being declared void by a court of law for not being Shariah compliant is a major factor when it comes to developing products, he added. “Without certainty, it becomes very challenging for a bank to structure products,” he added.

A criticism leveled at the Islamic wholesale market is that there are insufficient products, and that most tend to be of the plain vanilla lending variety, even though demand is more and more from corporations to have products similar to conventional ones, not just plain vanilla but also more sophisticated ones.” BNP Paribas Najmah’s Tripon said banks should tread carefully in this area with regard to Shariah law.

But, does the market need more sophisticated and complicated products?

“As long as they don’t help or support the real economy, then no way. Islamic banking finances the real economy, so we deliver products that meet this requirement and not whether they can make more money,” Tripon emphasized.

Appendix 1

Summery Basel III Accord

Under the new rules, banks will be required to hold at least 7% of common equity, which is over three times higher than the existing minimum level. Banks will be required to hold:

0.4.5% of common equity to meet the core Tier 1 capital requirement; and

0.further 2.5% of common equity to meet the capital conservation buffer requirement.

The impact of the increase of the minimum level of common equity from 2% to 7% should be assessed in combination with the rest of the Basel III reform, including new trading book requirements, a new leverage ratio and minimum liquidity requirements. Despite these significant changes, press reports suggest that most internationally active banks are expected to meet the Basel III requirements without the need to raise further capital. However, it may still be too early for banks to relax as the Basel Committee has stated that “systemically important banks” should have loss absorbing capacity above the 7% level of common equity. Whilst it is currently an open question whether the Basel Committee will have an appetite for further raising the threshold for common equity for systemically important banks, work continues on the part of the Financial Stability Board (the FSB) and various Basel Committee work streams with a view to developing an integrated approach to regulation of systemically important financial institutions. Options include a new resolution regimes, capital surcharges, contingent capital and bail-in debt.

Banks will also be subject to a so called countercyclical buffer requirement within a range of 0% – 2.5% of common equity or other fully loss absorbing capital (endorsed by the relevant national regulator). Details of this requirement are still being finalised.

To mitigate the potential economic impact of these new requirements, the new level of capital standards will be implemented gradually between January 2013 and January 2019. We note that this is not consistent with the transition requirements proposed under CRD II and, therefore, amendments to CRD II (which were significantly more generous) will be expected.

The minimum capital requirement for common equity will be raised from the current 2% level, before the application of regulatory adjustments. This will be phased in by 1 January 2015 (see below for details).

The total Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter loss absorbency criteria, will increase from 4% to 6% over the same period. Failure to meet this requirement will result in restrictions of a bank’s ability to pay dividends and discretionary bonuses.

The capital conservation buffer above the regulatory minimum requirement will be calibrated at 2.5% and will be met with common equity, after the application of deductions. Failure to meet this requirement will result in restrictions of a bank’s ability to pay dividends and discretionary bonuses.

The Basel Committee reiterated its commitment to introduce another capital buffer designed to prevent the build-up of credit bubbles, a so called countercyclical buffer. The countercyclical buffer will be within a range of 0% – 2.5% of common equity or other fully loss absorbing capital (to be implemented according to national circumstances). Details of this requirement are yet to be finalised.

The Basel Committee also confirmed its intention to introduce the leverage ratio as set out in the announcement by the Bank Committee on 26 July 2010.

The Basel Committee made it clear that systemically important banks should have loss absorbing capacity above the 7% level. This statement refers to the ongoing work by the Basel Committee and the Financial Services Board which is designed to further strengthen the resilience of the financial system through a series of measures, including capital surcharges, bail-in and a new resolution regime for systemically important banks.

Transitional arrangements and grandfathering of existing capital instruments

National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date.

1) Capital ratio

As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

0.3.5% common equity/RWAs;

0.4.5% Tier 1 capital/RWAs, and

0.8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015:

0.on 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%;

0.on 1 January 2014, the minimum common equity requirement will rise to meet a 4% minimum common equity requirement and the Tier 1 requirement will rise to 5.5%; and

0.on 1 January 2015, the minimum common equity requirement will rise to 4.5% common equity and the Tier 1 requirement will rise to 6%.

2) Deductions

The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, will be fully deducted from common equity by 1 January 2018 and will be phased in as follows:

0.the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014;

0.40% on 1 January 2015;

0.60% on 1 January 2016;

0.80% on 1 January 2017; and

0.reach 100% on 1 January 2018.

During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

3) Capital conservation buffer

The capital conservation buffer will be phased in between 1 January 2016 and year end 2018, becoming fully effective on 1 January 2019. It will be phased in, so that it will be:

0.0.625% of RWAs on 1 January 2016; and

0.increased each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019.

National authorities will have the discretion to impose shorter transition periods and are encouraged to do so where appropriate.

4) Existing public sector capital injections

Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

5) Capital instruments that no longer qualify as common equity Tier 1

Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described under paragraph 4 above:

0.they are issued by a non-joint stock company;

0.they are treated as equity under the prevailing accounting standards; and

0.they receive unlimited recognition as part of Tier 1 capital under current national banking law.

Only those instruments issued before 12 September 2010 will qualify for the transition arrangements numbered 4 and 5.

6) Leverage ratio

The phase-in arrangements for the leverage ratio announced in the 26 July 2010 announcement have been confirmed:

0.the supervisory monitoring period will commence 1 January 2011;

0.the parallel run period will commence 1 January 2013 and run until 1 January 2017; and

0.disclosure of the leverage ratio and its components will start 1 January 2015.

Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

7) Liquidity coverage ratio and net stable funding ratio

After an observation period beginning in 2011, the liquidity coverage ratio will be introduced on 1 January 2015.

The revised net stable funding ratio will move to a minimum standard by 1 January 2018

Conclusion

It may be too early for either the industry or the Basel Committee to claim victory over the finalised global capital standards for banks as the work to strengthen the financial system still continues. In particular, the Basel Committee is still working on the proposal to increase loss absorbency of regulatory capital, which is open for consultation until 1 October 2010. When implemented, this proposal may substantially restrict banks’ flexibility in respect of capital instruments making it more difficult and costly for banks to raise capital if needed. This should be viewed in combination with new more restrictive requirements for capital deductions which will limit the extent to which banks can rely on minority interests, deferred tax assets and mortgage servicing rights. The cumulative effect of the new loss absorbency criteria and the new stricter requirements in respect of capital deductions will mean that it will be significantly more expensive for banks to raise even the same amount of capital, let alone a triple amount of that.

Whilst the Basel Committee announced its intention to allow “some prudent recognition” of minority interests and relax some other controversial parts of the Basel III proposal in its 26 July 2010 announcement, details of the finalised agreement on deductions and other parts of the Basel III reform, including the credit valuation adjustment, have not been released and it is impossible at this stage to predict the overall impact of the Basel III reform on banks’ capital.

These details are expected to be released as part of the complete Basel III package of capital and liquidity reform to be published in time for the G20 Leaders’ Summit in Seoul, South Korea on 11-12 November 2010. However, further proposals are expected before the end of 2010, including on contingent capital instruments and the net stable funding ratio. Those proposals and the rest of the capital and liquidity reform introduced by the Basel Committee will need to be separately agreed between the EU member states and the European Parliament and then transposed into national law in each member state. In the past the EU has demonstrated its utmost commitment to introduce draft European law to implement the Basel III proposals promptly. There is no reason to believe that the EU will not be as quick this time.

Regards
ZULKIFLI HASAN

  • Sarajevo, Bosnia and Herzegovina

    0 Comments

    1. Katherine says:

      Have you ever thought about adding a little bit more than just your articles?
      I mean, what you say is valuable and all. Nevertheless
      imagine if you added some great images or video clips to give your posts
      more, “pop”! Your content is excellent but with images and video clips, this website could
      undeniably be one of the most beneficial in its niche.
      Very good blog!

    Leave a Reply

    SUBSCRIBE

    Get the latest posts delivered to your mailbox:

    Page Reader Press Enter to Read Page Content Out Loud Press Enter to Pause or Restart Reading Page Content Out Loud Press Enter to Stop Reading Page Content Out Loud Screen Reader Support