basel iii impacts on ifsi and role of the ifsb by abdullah haron

Islamic Financial Services Board

Basel III: Impacts on the IIFSpand the Role of the IFSBBriefing/Workshop on Islamic LiquidityBriefing/Workshop on Islamic Liquidity

Management & Capital Market5-6 May 2012

Abdullah HaronAbdullah HaronAssistant Secretary General

About the IFSB

Introduction

• Based in Malaysia officially inaugurated on 3 November 2002 andBased in Malaysia, officially inaugurated on 3 November 2002, and started its operation on 10 March 2003

• Serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring thesupervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market and takaful

• To this end the work of the IFSB complements BCBS IOSCO andTo this end, the work of the IFSB complements BCBS, IOSCO and IAIS

2

About the IFSB cont’d

Objectives

• Develop standards & recommend its implementationDevelop standards & recommend its implementation• Provide guidance on effective supervision and regulation & develop

risk management & disclosure criteria• Establish cooperation with standard international setting bodies &• Establish cooperation with standard international setting bodies &

member countries• Enhance & coordinate initiatives to develop instruments and

procedures for efficient operation and risk managementprocedures for efficient operation and risk management• Encourage cooperation among member countries• Facilitate capacity building and development of human capital• Undertake research• Establish database• Miscellaneous objectives agreed by the General Assembly

3

j g y y

About the IFSB cont’d

187 members from 43 jurisdictionsj

By organisational demarcationBy membership type

2727

2626

Regulatory / supervisory authorities

Inter-governmental Associate MemberAssociate Member

Full MemberFull Member 5353

882626

134134

organisations

Financial institutions and professional firmsObserver MemberObserver Member

Associate MemberAssociate Member 88

126126Membership as at March 2012

4

AgendaB k d R l t F k• Background: Regulatory Framework

• Basel III Framework: An overview

• Nature of the regulated IIFS

• Impacts of Basel III to IIFS

• The Role of the IFSB• The Role of the IFSB

5

Background: Regulatory Framework

Background: Regulatory Framework

AAOIFI: CAR AAOIFI: CAR --excludes risks borne excludes risks borne

IFSB: capital based on IFSB: capital based on the adaptation of Basel II the adaptation of Basel II

standardized formula standardized formula --excludes risks borne by excludes risks borne by the PSIAthe PSIA (standard and(standard and

IFSB: special issues in IFSB: special issues in capital adequacy on capital adequacy on

securitization and realsecuritization and real

2010201019881988 19961996 20062006

by PSIAby PSIA the PSIA the PSIA (standard and (standard and supervisory discretion)supervisory discretion)

securitization and real securitization and real estateestate

G30 recommendations 1994G30 recommendations 1994Basel risk management guidelines for derivativesBasel risk management guidelines for derivatives

2010201020062006

Basel risk management guidelines for derivatives Basel risk management guidelines for derivatives Minimum requirements for trading activitiesMinimum requirements for trading activitiescredit risk treatmentcredit risk treatment

CapitalCapital00--8% based 8% based

di i kdi i k

Capital based Capital based on credit riskon credit risk

on credit riskon credit riskequivalentsequivalents

(also to cover other (also to cover other risks)risks)

-- Standard method Standard method -- Int. rating based Int. rating based

methodmethodAs well as op risk and As well as op risk and

Market risk chargesMarket risk charges

MR StandardMR Standardor Model *3plusor Model *3plus

plus specific riskplus specific riskBasel IIIBasel III

7

Market risk chargesMarket risk chargesplus specific riskplus specific risk

Background: Regulatory Framework cont’d

Supervisory review processSupervisory

Supervisory review processAction

Financial(Capital Adequacy)

Governance and Risk management

DisclosuresRegulatoryRequirements

Basic conditions for the effective

The IIFS supervisory authority{P diti the effective functioning of The IIFS sector{Preconditions

8

The IFSB standardsIt i i t t t t th ti f b l i thIt is important to note the notion of balance in the regulatory requirements of IIFS and the supervisory review programme employed in this context.

The supervisory authorities will have to exercise judgement regarding the appropriate weights and balance to be given in the application of qualitative and quantitative measures in their policies on capital adequacy riskmeasures in their policies on capital adequacy, risk management, corporate governance and disclosure requirements.

9

Development of the IFSB standards

Standard Commencement of preparation

Issuance

Risk management 2003 2005Risk management 2003 2005

Capital adequacy 2003 2005

Corporate governance 2004 2006

Transparency & market discipline

2005 2008

Supervisory review process 2005 2008Supervisory review process 2005 2008

10Note : * corresponds to the date of the 1st meeting of the Working Group

Development of the IFSB standards cont’d


Issuance

Special issues in capital 2006 2008Special issues in capital adequacy

2006 2008

Governance of investment fund 2006 2008

G f T k f l t 2006 2009Governance of Takaful operator 2006 2009

Sharī`ah governance 2007 2009

Conduct of business 2007 2009Conduct of business 2007 2009

Solvency for Takaful 2008 2010

Liquidity risk 2010 2012Liquidity risk 2010 2012

Stress testing 2010 2012


Development of the IFSB standards cont’d


Issuance

Risk management in Takaful 2011 2013 (ED)Risk management in Takaful 2011 2013 (ED)

Revised capital adequacy standard

2011 2013 (ED)

Revised supervisory review 2012 2014 (ED)Revised supervisory review process

2012 2014 (ED)


Basel III Framework:An Overview

Basel III Framework: An Overview

Basel III: Capital and Leverage•More restrictive definition of capital•More demanding capital ratios, bigger capital buffers•Higher capital charges for counterparty risk•Formal leverage ratio

The Global Reform Agenda

Microprudentialg

Basel III: Quantitative Liquidity Standard•Liquidity Coverage Ratio: to survive 1-month stress•Net Stable Funding Ratio: to require longer term

Reform Agenda

•Net Stable Funding Ratio: to require longer term funding sources

Systemic Risk•SIFIs Too big too fail

Macroprudential

SIFIs Too big too fail•Surcharges•Levy and resolution funds•OTC derivatives and central clearing•Non-bank financial institutions

Compensation, Cross Border Resolution, Countercyclical Provisioning, Accounting

14

Basel III Framework: An Overview cont’dCapital Leverage Ratio Liquidity Ratio

1a. Increased quantity

•Rise in the overall capital ratios

•Forward looking provisionsf

Liquidity coverage ratio•High quality liquid assets to cover a 30 day stress

Leverage ratio•Includes both on-balance sheet and adjusted off-

2. Enhanced risk coverage and new capital standards for

counterparty credit risk

3. Leverage ratio 4. Liquidity ratio

•Additional requirements for systemically important institutions

cover a 30 day stress scenario

Net stable funding ratio•Measure of structural liquidity

•Based on a long term (1

sheet and adjusted offbalance sheet assets

•A minimum threshold of 3%Credit risk Market risk

Higher capital requirements•Trading book exposures•Securitization exposures1b. Capital buffer

•Based on a long term (1 year) funding requirement

Monitoring metrics•Contractual maturity mismatch1c. Increased quality

Counterparty credit risk•CVA risk•Wrong way risk•Move towards central

•ResecuritizationCapital conservation

Procyclical adjustment

•Concentration of funding•Available unencumbered assets

•Market related monitoring tools

Tier 1: Tighter eligibility standards

To be phased out:•Capital instruments other than common equity

Move towards central counterparties

Tier 2: Simplified

•Intangibles•Deferred tax assets•Other items

Tier 3: Abolished

15

Basel III Framework: An Overview cont’dHigher Minimum Capital Adequacy Requirements

2 5%2 5%

11.75% 2.5%2.5%

11.875% 2.5%2.5%

13%

2.5%2.5%

13%

2.5%2.5%

13%

2.5%2.5%

13%14%

12%Counter Cyclical Buffer

Higher Minimum Capital Adequacy Requirements

2.5%2.5%

11.125%

1.25%1.25%

2.5%2.5%

1.85%1.85%

2.5%2.5% 2.5%2.5% 2.5%2.5% 2.5%2.5%

ed A

sset

s

10%Capital Conservation Buffer

4%4% 3.5%3.5% 2.5%2.5% 2%2%

8% 8% 8% 8%2%2%

0.625%0.625%

2%2% 2%2% 2%2% 2%2% 2%2% 2%2%

% o

f Ris

k W

eigh

t

8%

6%

Other Capital

2%2%

3 5%3 5%

1%1%

4%4%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%

4.5%4.5%

1.5%1.5%%

4%

Other Tier I Capital

Tier I Common Equity

2%2%

3.5%3.5%

2%

0%

Equity

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 20222010

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Basel III Framework: An Overview cont’dTimelineTimeline

2011 2012 2013 2014 2015 2016 2017 2018 2019Minimum common equity capital ratio 3.50% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50%

Capital conservation buffer 0 625% 1 25% 1 875% 2 50%Capital conservation buffer 0.625% 1.25% 1.875% 2.50%Minimum common equity plus capital conservation buffer 3.50% 4.00% 4.50% 5.125% 5.75% 6.375% 7.00%

Phase in of deductions from CET1 (inc. amounts exceeding the limit for DTAs, MSRs and 20% 40% 60% 80% 100% 100%

financials)

Minimum Tier 1 capital 4.50% 5.50% 6.00% 6.00% 6.00% 6.00% 6.00%

Minimum total capital 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%

Minimum total capital plus 8 00% 8 00% 8 00% 8 625% 9 25% 9 875% 10 50%conservation buffer 8.00% 8.00% 8.00% 8.625% 9.25% 9.875% 10.50%

Capital instruments that no longer qualify as non-core Tier 1 or Tier 2 capital

Phased out over 10-year horizon beginning 2013

Leverage ratio Supervisory monitoring Parallel run 1 January 2013 – 1 January 2017 Disclosure starts 1 January 2015 Migration to Pillar 1 Disclosure starts 1 January 2015

Liquidity coverage ratio Observation period begins

Introduce minimum standard

Net stable funding ratio Observation

period Introduce minimum

begins standard

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Basel III Framework: An Overview cont’d

Increase quantity of capital

Better quality of capital

Global Capital Framework

Capital Impact Equity capital to increase by 25%- 40%* or more, banks will need to look at ways to

optimize the use of capital Additional Tier 1 capital need is almost 60% of the current Tier 1 outstanding capital The deferred tax assets change and the new capital instruments will have significant tax Better quality of capital

New leverage ratio

Risk Coverage

g p gimplications

Fall in ROE is 3.7% when not considering impact of NSFR and 4.3% when considering its impact on NSFR

Cost of capital may increase as debt is replaced by equity Restructuring of balance sheet to dispose phased out capital instruments and optimize

Risk CoverageIncreasing capital charges

Counterparty credit risk

usage of capital

Global Requirements for Liquidity Buffers

Liquidity coverage ratio

Net Stable funding ratio

Monitoring liquidity risk

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New leverage ratio

Risk CoverageRisk CoverageIncreasing capital charges




Liquidity Impact Additional 40% requirement for liquidity over the liquidity buffer held currently Require an additional increase of 10 – 15% of stable funding over the currently available

stable funding Liquidity risk stress testing and reporting pose challenges for many banks



Liquidity risk, stress testing and reporting pose challenges for many banks Impact on income as bank invests in more liquid investments and curtailed loans maturity

to match available stable funding Increased cost of liquid funds as demand increases and high interest costs of holding

stable funds

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Implementation issues and Operational costsBetter quality of capital

New leverage ratio

Risk Coverage

Additional costs of implementation of systems for Basel III compliance is estimated to be between 30 – 50% of outlays for Basel II implementation

Interdependence and complexity in designing systems to capture granular data for modeling and stress testing

Drafting and incorporating new risk management policies and processes Increased operational costs of monitoring reporting and being compliant by 2012Risk Coverage

Increasing capital charges

Counterparty credit riskStrategic implications Restructuring or disposals of some business units to optimize usage of capital Inability to provide full-fledged services or products (trading, securitization) due to

increasing capital charges and restrictions which can be up to a factor of 10 for

Increased operational costs of monitoring, reporting and being compliant by 2012



c eas g cap ta c a ges a d est ct o s c ca be up to a acto o 0 osecuritization

Pressure to increase lending spreads leading to possible loss of valuable customers

Risk of falling below shareholder ROE expectation Growth can take a backseat with increased capital, liquidity and leverage



requirement

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Nature of the regulated IIFSNature of the regulated IIFS

Stylised Balance Sheet of an IIFS

ASSETS

Cash & cash equivalents

LIABILITIES

Current accountsq

Sales receivables

Investment in securities

Investment in leased assets

Other liabilities

Equity of Profit Sharing InvestmentInvestment in leased assets

Investment in real estate

Equity investment in joint ventures

Equity of Profit Sharing Investment Accounts (PSIA)

Profit Sharing Investment Accounts (PSIA)

Equity investment in capital ventures

Inventories

Other assets

Profit equalization reserve

Investment risk reserve

Fixed assets Owners’ Equity

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Risks: IIFS vis-à-vis conventional banks• Unlike the predominantly borrowing and lending operations• Unlike the predominantly borrowing and lending operations

performed by conventional banks, the stylized balance sheet of an IIFS suggests that its business activities resemble a “one-stop shopping” model.resemble a one stop shopping model.

• The nature of risks to which an IIFS is exposed is not necessarily the same as those of a conventional bank.y

• IIFS do not have the option to sell at a discount or to repackage and sell off their financial assets (e.g.

i bl ) i i hi h hi hreceivables) as securities, which represent a high percentage of total assets, in order to take the risk off their balance sheet.

23

T f Ri k D fi iti

Risks: IIFS vis-à-vis conventional banks cont’dType of Risks Definition

Equity Investment Risk

The risk arising from entering into a partnership for the purpose of undertaking or participating in a particular fi i l b i ti it d ib d i thfinancing or general business activity as described in the contract, and in which the provider of finance shares in the business risk. This risk is relevant under Muḍārabah and Mushārakah contracts.a d us ā a a co ac s

Rate of Return Risk The potential impact on the IIFS’ returns caused by unexpected change in the rate of returns.

Displaced The risk that the IIFS may confront commercial pressureDisplaced Commercial Risk

The risk that the IIFS may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. The IIFS forgoes part or its entire share of profit in order t t i it f d id d di d th fto retain its fund providers and dissuade them from withdrawing their funds.

Sharī`ah Noncompliance Risk

Risk arises from the IIFS’ failure to comply with the shariah rules and principles

24

Noncompliance Risk shariah rules and principles.

Risks: IIFS vis-à-vis conventional banks cont’dOverall IIFS have been well capitalised since theyOverall, IIFS have been well capitalised since they

started their operations. Tier 1 and total capital requirements currently stand at 8% and 12% respectively.respectively.

• IIFS have non-financial assets in their balance sheets

C it l h ith t t i t i k–Capital charges with respect to inventory risk

• Majority of Islamic banks assess their credit risks by applying the standardised approachapplying the standardised approach

–Lack of data and smaller sample size

25

Risks: IIFS vis-à-vis conventional banks cont’d• IIFS enjoy additional buffer through loss sharing nature of• IIFS enjoy additional buffer through loss sharing nature of

Muḍārabah contract – the risks of assets funded by the PSIA under the Muḍārabah contract are excluded from the calculation of CAR.calculation of CAR.

• The IIFS could use Investment Risk Reserve (IRR) and Profit Equalisation Reserve (PER) to protect the PSIA q ( ) pinvestors from financial risks.

• The IIFS will bear losses for the risks arising from li i d i i i h PSIAnegligence or misconduct on its part in managing the PSIA

– operational risk.

26

Impact of Basel III on IIFSImpact of Basel III on IIFS

Impacts of Basel III to IIFS




Current ScenarioBasel III approaches to enhance the quality of capital. The enhancement changes the

demographic of debt based capital to one of equity. IIFS already have a higher proportion of equity as capital.Basel III covers buffer capital ratios introduced via the Capital Conservation Buffer andBetter quality of capital

New leverage ratio

Risk Coverage

Basel III covers buffer capital ratios introduced via the Capital Conservation Buffer and Counter Cyclical Capital Buffer. The IIFS have introduced Investment Risk Reserve and Profit Equalisation Reserve.

Capital ImpactRequire IIFS to hold much more of the best form of capital while some of the existing capitalRisk Coverage

Increasing capital charges


Require IIFS to hold much more of the best form of capital while some of the existing capital will cease to count.Deductions from capital will increasingly be made from core tier 1.Dividends and bonuses will be constrained to boost core tier 1.IIFS will have to hold purer liquidity in larger amount and match closely between their lending

and deposit base.



pA large part of the IIFS’ profits over the next decade will go into the new standing funds.

Leverage RatioPSIA cannot be included in additional Tier1 capital because they do not meet the criteria set

out by the Basel III.Net Stable funding ratio


out by the Basel III.Assets financed by the PSIAs are excluded from the exposure measure because the PSIAs

are not included in the Tier 1 capital.Generally, IIFS are not highly leveraged due to the strict prohibition of 33% debt to equity

ratio.In summary, no noticeable impact on IIFS positions.y, p p

28

Impacts of Basel III to IIFS cont’d





New leverage ratio

Risk Coverage Current ScenarioRisk CoverageIncreasing capital charges


Current ScenarioLiquidity has been a major issue in Islamic finance due to the nature of Islamic financial

instruments and contracts which tend to be short to medium term given the lack of depth in the long-term liquidity market.Challenges also include a) lack of appropriate standardised liquidity instruments, b) limited

capability to transfer fund across borders, and c) reliance on retail funding which locks the



p y ) gIIFS to domestic markets.

Liquidity Requirement ImpactHighly rated Sukuk are considered to meet the stock liquidity requirements.Th d t i t i t k f t th t b t d i t h i th i d t



The need to maintain a stock of assets that can be turned into cash requires the industry stakeholders to collaborate with one another.Treatment of PSIA and other sources of funds with respect to the run-off in the calculation of

liquidity ratio.The role of rating agencies will play a role in determining sukuk rating.

29

Impacts of Basel III to IIFS cont’d



Global Capital Framework Tier 1 is already

the case of IIFS

Tier 3 is limited inBetter quality of capital

New leverage ratio

Risk Coverage

Tier 3 is limited in IIFS

PER and IRR playRisk CoverageIncreasing capital charges

Counterparty credit risk Leverage is already low in IIFS

PER and IRR play similar role in forward looking provision and

counter cyclical capital



already low in IIFS

Shari`ah compliant I t t



Instruments

Establishment of the IILM

30

The Role of the IFSBThe Role of the IFSB

The Role of the IFSB

Against the backdrop of the global financial crisis and economic downturn, regulatory authorities have focused on securing financial stability and rebuilding the trust of various stakeholders in the industry.

Basel Committee addresses the weaknesses through both micro and macro prudential measures in its current work.

Micro Macro

Task 2: Improve the coverage of risk

Task 1: Introduce a leverage ratio

Task 2: Introduce measures to raise capital in d ti th t th b d d i

Task 1: Raise the quality of capital

Task 3: Require much higher levels of capital to absorb the types of losses associated with the crisis

T k 4 I t d l b l li idit t d d t

good times so that they can be drawn down in periods of stress to reduce procyclicality

Task 3: Require globally systemic banks to have additional loss absorbanccy

Task 4: Introduce a global liquidity standard to supplement the capital regulation

y

Task 5: Introduce stronger supervision, risk management and disclosure standards

The Role of the IFSB cont’dThe IFSB issued two new guiding principles on: 1)The IFSB issued two new guiding principles on: 1)

Liquidity Risk Management and 2) Stress Testing for institutions offering Islamic financial services (IIFS).

–The liquidity risk management endeavors to delineate a set of guiding principles for the robust management of liquidity risk by IIFS and its vigorous supervision and monitoring by supervisory authorities taking intomonitoring by supervisory authorities, taking into consideration the specificities of IIFS and complementing relevant existing and emerging international standards and best practicesinternational standards and best practices.

–The stress testing aims to provide a set of guiding principles intended to complement the existing p p p ginternational stress testing framework.

33

The Role of the IFSB cont’dThe IFSB has formed a working group last year aimingThe IFSB has formed a working group last year, aiming

to revise the existing IFSB standards on capital adequacy including sukuk, securitisation, real estates

–Not to put IIFS at a disadvantageous position;

–Provide guidance on capital adequacy treatment of j Sh i’ h li t d tmajor Shari’ah compliant products;

–Offer enough flexibility;

–Address the peculiarities of IIFS with respect to various components of eligible capital, while taking into account the prevailing experiments by some IIFS to raise capitalthe prevailing experiments by some IIFS to raise capital through innovative Shari’ah compliant structures; and

–Promote robust risk management

34

Promote robust risk management.

The Role of the IFSB cont’dThe IFSB is working on revising the IFSB 5 in order toThe IFSB is working on revising the IFSB-5 in order to

ensure that the review process covering IIFS will be consistent with those for conventional institutions and relevant to the current state of the industry, whilerelevant to the current state of the industry, while catering for the specificities of Shari’ah-compliant financial transactions. In this respect, the working group will consider:

– the specificities of the IIFS (through reviewing the feedbacks in the IFSB workshops, seminar etc);

– the lessons learned from the financial crisis; and

– the existing international standards on supervisorythe existing international standards on supervisory review process such as that of the BCBS and EBA.

35

Th k f tt tiThank you for your attention

[email protected]

References1. M. Hasan, “Impact of Basel III on Islamic Banks”, IMF-STI Seminar on Islamic Banking, Oct 20112. KFH Research Limited, “Basel III Impact on Islamic Banking”, Islamic Finance Research, Aug 20113 S Srivastava “Introduction to Basel III” IFSB Seminar on Risk Mitigation and Enhancing Financial3. S. Srivastava, Introduction to Basel III , IFSB Seminar on Risk Mitigation and Enhancing Financial

Stability in Islamic Finance: Contingent Capital and Takaful, Jan 2011

basel iii impacts on ifsi and role of the ifsb by abdullah haron

Business

liquidity risk

capital adequacy2003

development of human

capital adequacy riskadequacy

ed standard

psia standard

international standard

demanding capital ratios