Overview of the Lebanese Economy - Raed H. Charafeddine · Islamic banks are significantly...

I

Outline

Regulatory capital requirements

1- Capital Management : Differences between Conventional and

Islamic Finance

2- Impact on the Islamic capital requirement

3- Overall assessment

Capital Management in Islamic Finance 2 Raed H. Charafeddine Banque du Liban

II

Liquidity buffers requirements

1- Liquidity risk and types

2- Impact on the Islamic liquidity requirement

3- Overall assessment

Raed H. Charafeddine Banque du Liban



I.1- Different Types of Risks between Conventional

and Islamic Financial Institutions

Conventional Banking

Islamic Banking

Credit Risk Credit Risk

Market Risk Market Risk

Liquidity Risk Liquidity Risk

Operational Risk Operational Risk

_ Displaced Commercial Risk

_ Legal and Shari’ah Risk





I.1- Implications of Profit –Sharing Investment

Accounts on Capital Adequacy


Unrestricted Profit Sharing

Investment Accounts

Deposit-Like Product

(Implicit Fix Return and Capital guarantee)

Investment Product

(Variable Return, Non-Capital Guaranteed)

Characteristics and Supervisory

Considerations

Risks

Risks borne by shareholders

Risks borne by Investment Account

Holders except in the case of negligence and/or misconduct

Implications on Capital Adequacy

0

1

α

Products

Source: Supervisory, regulatory, and capital adequacy implications of profit –sharing investment accounts in Islamic Finance, ( Archer , Abdel Karim and

Sundararajan 2010)




I.5 - Implications of the supervisory determination of

the α factor


0 1

Capital Adequacy Ratios are highly sensitive to α factor

α

If supervisory

authorities act as

though α is equal

to 0 when it

should be close

to 1

If supervisory

authorities act as

though α is close

to 1 when it

should be close

to 0

Islamic banks

are significantly

undercapitalized

Islamic banks

carry excess

amounts of

capital which

will affect their

competitiveness Source: Supervisory, regulatory, and capital adequacy implications of profit –

sharing investment accounts in Islamic Finance, Archer – Abdel Karim and Sundararajan (2010)

I.2- Conventional and Islamic Capital Requirement

Reforms: Timelines


International

Convergenc

e of

Capital

Measureme

nt and

Capital

Standards

June 2006

Proposed

revisions to the

Basel II Capital

Markets Risk

Guidelines for

Computing Capital

for Incremental

Risk in the Trading

Book

June 2011

Basel III: A global

regulatory

framework for more

resilient banks and

banking systems -

Revised version

December 2010

Guidance for

national authorities

operating the

countercyclical

capital buffer

Enhancements to

the Basel II

framework

Revisions to the

Basel II market

risk framework

Guidelines for

computing capital

for incremental

risk in the trading

book

July 2008

Global Systemically

Important Banks :

Assessment methodology

and the additional loss

absorbency

Nov. 2011

IFSB-2

Capital

Adequacy

Dec. 2005

IFSB-7

Capital Adequacy

Requirements for

Sukuk,

Securitization and

Real

Estate Investments

Jan. 2009

ED-15:

Revised

Capital

Adequacy

Standard for

Institutions

Offering

Islamic

Financial

Services

Nov. 2012 Mar. 2008

GN1

Recognition

of ECAIs on

Shariah

Compliant

Financial

Instrument

GN 2

Commodity

Murabaha

Transactions

GN 3

Practice of

Smoothing the

Profits Payout to

Investment Account

Holders

July 2009

Mar. 2011

GN4

The determination

of Alpha in the

Capital Adequacy

ratio for IIFS

I.2- Global Financial Reforms toward enhancing

regulatory capital: Impact on IFSI regulation

Global Financial Reforms : How Did they impact the IFSI ?

7 Raed H. Charafeddine Banque du Liban

BASEL III New Capital

Requirement

A. Increase in bank’s capital quality,

consistency and transparency

• Greater focus on Common Equity;

Tier 2 simplified (no upper & lower) ;

Tier 3 will be phased out;

• Innovative Hybrid capital instruments

with an incentive to redeem will be

phased out;

• Stricter Definition through stringent

deductions.

Impact on Islamic Prudential

Regulation (PED 15)

A. Increase in bank’s capital quality,

consistency and transparency

• Criteria for Common Equity Tier-1,

Additional Tier-1 and Tier-2, in line

with Basel III. PSIA are not qualified

as part of the core or additional

capital. PER and IRR may not be

included in any Tier of the capital.

• Inclusion of hybrid Sukuk as well as

Convertible Contingent Capital

(CoCos) for IIFS. Subordinated

Sukuk in principle are impermissible.

• Inclusion of Zakat Deduction under

Regulatory adjustments/deductions.






Requirement

B. Credit Risk Weights

•Credit conversion factors (CCF) for off

balance sheet items have been made

uniform at 50%, regardless of the maturity

of the liquidity facility.


Regulation (PED 15)

B. Credit Risk Weights

• Eligible lines of financing less than one

year still receive a 20% CCF

•Credit Risk Mitigation Techniques :

Enlarged scope to cover on-balance

sheet netting

•Explanation of multiple CRM to cover a

single exposure

• A more specific reference to export

guarantee schemes used by IIFS to

cover their trade financing netting.






Requirement

C. Market Risk Weights

•Equity Position Risk : capital charge for

specific and general market risks have

been made uniform at 8% for all types of

portfolios.

•Advanced techniques.

• Calculate specific risk capital charge for

the “correlation trading portfolio”.

•Revised method of calculating specific

risk capital charge for the securitisation

positions in the trading book.


Regulation (PED 15)

C. Market Risk Weights

•Equity Position Risk : Same capital

charge for specific and general market

risks.

• IRB approaches not covered.

•Include the duration method for the

calculation for trading positions in Sukuk.

•Revised method of calculating specific

risk capital charge for the securitisation

positions in the trading book .






Requirement

D. Operational Risk Weights


Regulation (PED 15)

D. Operational Risk Weights

• Not covered Advanced Measurement

Approach.

• Same eight lines of business and

percentages of annual gross income

(called beta).

• Allocating additional capital may not be

the optimal solution for covering Shari’ah

non-compliance risk, fiduciary risk and

legal risk as a part of operational risk.

Instead list of Shariah requirements and

explanation of unique operational risk

per type of instruments have been

provided.






Requirement

E.


Regulation (PED 15)

E. Adjusting the denominator for PSIA

• No change in the calculation of the

alpha factor

•CMT and Other deposits : important

capital adequacy issues associated with

such transactions are included

•Wakalah and Musharakah as PSIA :

Distinct features and treatment.






Requirement

F.


Regulation (PED 15)

F. Minimum Capital Requirement for

Islamic Financing Assets

• Coverage of the capital treatment of

CMT, and Qard ul Hassan, Wakalah.

• Coverage of the capital treatment of

Shari’ah compliant derivatives.

• Capital requirements for exposures of

IIFS related to real estate financing and

investment activities.

• Capital adequacy treatment of an IIFS’s

involvement in Sukūk issuance and

securitisation processes in various

capacities, including as originator,

servicer and credit enhancer.


regulatory capital: Is there an impact for IFSI?



Requirement

G. Increase in the required level of

capital • Increase of the minimum common

equity requirement from 2%

(equivalent to 1% according to the

new def) to 4.5%;

• Increase of the Tier 1 minimum

capital requirement from 4%

(equivalent to 2% according to the

new def) to 6%;

• Additional Capital conservation

buffer of 2.5% of common equity to

withstand future periods of stress;

The required total common equity

will be brought to 7%, Tier 1 capital

8.5% and Total Capital 10.5%.


Regulation (PED 15)

G. Increase in the required level of

capital

• Same increase in the required

level capital.

• Same requirement for the Capital

Conservation buffer and

minimum capital conservation

ratios.

• Same requirement for the

preparation of a Capital

Conservation Plan on a

contingency basis.





Requirement

H. Introducing a non-risk-based

leverage ratio

Simple leverage Ratio, as a backstop

to the Risk based capital measure

Tier1/Assets > 3%


Regulation (PED 15)

H. Introducing a non-risk-based

leverage ratio

Same computational details for the

leverage ratio.





Requirement

I. Macroprudential Overlay for the

Reduction of Systemic Risk

• Reduce procyclicality : Introducing

the countercyclical capital buffer

calibrated in a range of 0 - 2,5% that

would require institutions to build up

defensive buffers in good times that

could be drawn down in bad times.

Implications on Islamic Prudential

Regulation (PED 15)

•Increased pro-cyclicality of IBs due to:

o In buoyant economic conditions : capital ratio are

enhanced as a result of increased profits , which

leads to higher reserves, lower requirement of

provisions against impairments and lower RWs

being applied to banking book assets.

oTendency to invest in real sector-related asset

classes may expose to cyclical impact of the

economic cycle in countries dependent on oil.

o The relying on External Credit Assessment

Institutions (ECAI) rating for the determination of

the risk weights.

oThe growing practice of raising term deposits and

making term loans based on reverse murabaha or

tawaruq transactions reduced the profit and loss

sharing financing forms.

Maintain counter-cyclical buffer under Pillar

II in line with Basel III.

I.2. Global Financial Reforms toward enhancing




Requirement

J. Macroprudential Overlay for the


• Account for the interlinkages and

common exposures: Additional loss-

absorbing capacity for Systemically

Important Financial Institutions

(systemic capital surcharge).

• Further guidance on Regional and

Domestic SIFIs will be provided.

K. Sufficient time for a smooth

transition


Regulation

J. Macroprudential Overlay for the


• No guidance on the treatment of the

G-SIFIs because no IIFS is listed

among the 29 G-SIFIs issued by the

Basel Committee.

• Further guidance on Regional and

Domestic SIFIs will be provided once

an agreement will be reached on the

global level.

K. Sufficient time for a smooth

transition


• Empirical data shows that most IIFS will not face a major difficulty meeting

2.5% capital conservation buffer requirement out of their CET1, above the

regulatory minimum capital requirements. As most of the capital of IIFS is

composed of common equity in many jurisdictions, IIFS will naturally be in a

good position to meet this requirement.

• IIFS will have to account for major considerations for issuance of contingent

convertible capital, among others:

•Which Shari’ah compliant structure will be most suitable?

•When will the Sukuk qualify for Additional Tier 1 or Tier 2?

•How to avoid element of gharar (excessive uncertainly)?

•What type of trigger to be used?

•What should be the conversion rate?

I.3 Overall assessment of the new capital

requirements for IIFS


• For various reasons, pro-cyclicality may be considered to be a less serious

problem in the IIFS than in conventional banks. The concept of

countercyclical buffer is also quite implementable on the IIFS.

• Most IIFS will not face any difficulty in meeting the leverage ratio as their

current leverage ratio is well below the 3%.

• IIFS can be considered having its important and interconnectedness at a

level that its insolvency can impact global financial system. Therefore, the

issue of Global SIFIs is not very relevant to the IIFS.

• DCR Estimation should be based on Supervisory rules and not just on a

discretion basis. Clearer methodology and data requirement should be made

available.

I.3 - Overall Assessment of New Capital

Requirements for IIFS

II.1. Liquidity Risk and Types



Funding Liquidity Risk

Bank is unable to meet its financial

obligations without affecting either daily

operations or the financial conditions.

Market Liquidity Risk

Bank is unable to unwind or offset

outstanding positions in the market

within a short span of time at or

near the previous market price

because of inadequate market

depth or market disruption.

II.2- Conventional and Islamic Liquidity Management

Reforms: Timelines


Sound

Practices for

Managing

Liquidity in

Banking

organizations

Feb. 2000

Liquidity Risk

Management

and Supervisory

Challenges

Dec. 2010

International Framework

for liquidity risk

measurement standard

and monitoring

Dec. 2009

Guidelines on

liquidity Buffers &

Survival Periods

Principles for

sound liquidity risk

management and

supervision

Feb. 2008

Revised full text on

Basel III liquidity

requirements

Jan. 2013

IFSB-12: Guiding Principles

on Liquidity Risk Management

for Institutions offering Islamic

Financial Services

Sep. 2008

Principles for

sound stress

testing practices

and Supervision

May.2009

Mar. 2012

IFSB-13: Guiding Principles

on Stress Testing for

Institutions offering Islamic

Financial Services

TN-1: Technical note on

issues in strengthening

liquidity management of

Institutions offering Islamic

Financial Services : The

development of Islamic Money

Markets

Mar. 2008

IFSB-1: Risk

Management

Dec. 2005

II.2. Global Financial Reforms toward enhancing

liquidity buffers: Impact on IFSI regulation


BASEL III new global minimum

liquidity standards

•New liquidity coverage ratio : promoting

short-term resilience by ensuring that it

holds a buffer of high-quality liquid assets

to deal with cash outflows in an acute

stress scenario lasting for one month.

LCR = Stock of high quality liquid assets /

Total net cash outflows overt the next 30

calendar days ≥ 100%

•New Net Stable Funding Ratio: address

funding mismatches over a time horizon of

one year and provide incentives to banks

to use stable sources to fund their

activities.

NSFR = Available amount of stable

funding / Required amount of stable

funding > 100%.


Regulation

• Currently Guiding Principles for

Liquidity Risk management for IIFS

and supervisors only.

• Suggested metrics and monitoring

tools are the same.

• IFSB is working on the preparation of

a separate Guidance Note on

quantitative tools for the

measurement and monitoring of

liquidity risk in IIFS, in line with

industry practices and other global

initiatives.


Islamic banks will face serious challenges to comply with the Basel III liquidity

requirements due to :

- the shortage of high quality liquid Islamic assets,

- the shortage of stable retail funding v/s wholesale funding which is still

significant small in comparison to the bank’s operations size,

- Low reliance on repurchase markets for interbank funding due to the slow

progress and disagreements on the possible alternatives to a Shariah

compliant repurchase agreement.

The overall impact will be the following:

• Increased cost of liquid funds as demand increases.

• IIFS income will be reduced as bank invests in more liquid investments and

reduce financing maturity to match available stable funding.

II.3 Overall assessment of the impact of Liquidity

requirements for IIFS


CONCLUSION

Three main takeaways :

1- Building a fail-safe financial system is impossible.

2- If the reform process can identify and mitigate these systemic risks,

the overall system will be more resilient.

3- Aligning the IFSB Standards and Guidelines with Global Capital and

Liquidity standards provides a level playing field to the IIFS vis-a-vis

market players.

Overview of the Lebanese Economy - Raed H. Charafeddine · Islamic banks are significantly...

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