The tough Basel III regulatory standards, also pose questions for Islamic lenders that could prove expensive:
- Will regulators treat their deposit the same way?
- How will this affect banks with separate Islamic branches.?
Islamic finance frowns on monetary speculation, so their balance sheets are largely clear of the derivatives and complex, risky assets that surfaced in other banks during the global financial crisis. These factors were reported for example last month in http://gulfnews.com/business/banking/islamic-banks-to-benefit-form-basel-iii-capital-rules-1.1373655 However, the issues are wider than the balancde shet.
Interest payments are not allowed by sharia principles, so Islamic banks obtain deposits mostly through profit-sharing investment accounts (PSIAs), which are generally considered to be more volatile than conventional deposits. So Islamic banks are expected to be required to offset that volatility under Basel III by increasing the amount of high-quality liquid assets (HQLAs) that they hold.
This is easier said than done. Islamic securities markets are relatively immature , than conventional markets, so sharia-compliant HQLAs are in short supply –
Islamic commercial banks held about $1.2 trillion worth of assets at the end of last year, according to a study by Thomson Reuters. Those banks account for roughly a quarter of deposits in Gulf Arab countries and over a fifth in Malaysia.
Basel III requires banks to hold enough HQLAs to cover net cash outflows for a 30-day period under a high-stress scenario. Outflows are calculated by applying different weights to funding sources, including PSIAs. The riskier the funding source, the larger the amount of HQLAs needed to cover it.
With the exception of Malaysia and Bahrain, few central banks actively issue instruments which qualify as HQLAs.. Government-issued sukuk qualify, but most sovereign sukuk are either not listed on developed markets or are not actively traded, making those very hard for Islamic banks to obtain. This contrasts with conventional banks’ access to huge markets in high-quality government debt such as U.S. Treasuries and German Bunds. Alternatives such as the short-term sukuk issued by the Malaysia-based International Islamic Liquidity Management Corp, which was established to promote a cross-border market in Islamic instruments, remain small compared with the overall size of the industry..
Much depends on the weightage or “run-off rates” that national regulators who will implement Basel III in their own jurisdictions, choose to assign to PSIAs.
Regulators are keen to develop their Islamic banking sectors, so are unlikely to assign punitive weights. However, they may not be able to treat PSIAs as benignly as conventional bank deposits. For instance, PSIAs held by Islamic banks tend to have relatively short maturities..
The uncertainty looks unlikely to be cleared up at least before next year, when the Malaysia-based Islamic Financial Services Board (IFSB), a global standard-setting body, is expected to release a guidance note on the subject.
The note will deal with issues such as the contractual rights of depositors, for example whether they can withdraw money in fewer than 30 days without a significant penalty, said a source familiar with the IFSB’s deliberations.
Malaysia’s central bank has issued some guidance on PSIAs, saying it will classify them as two types: general PSIAs, broadly equivalent to conventional retail deposits, and specific or restricted PSIAs, deemed similar to managed investment accounts. It has given Islamic banks a two-year transition period to differentiate between those types. Yet while the central bank has already spelled out ratios and weights for Basel III capital adequacy rules, it has not yet announced run-off rates or HQLA requirements for PSIAs.
Basel III says national regulators around the world could assign run-off rates of 3 per cent or higher to stable, conventional bank deposits, and as much as 10 per cent to less stable deposits, according to S&P. Islamic banks may end up being assigned numbers within that range; given the size of the deposits at stake, a variation of several percentage points will make a big difference to how much HQLAs the banks are forced to hold.
The PSIA issue may increase pressure on central banks and governments to address longstanding problems in Islamic finance.
As part of its efforts to develop as an Islamic financial centre, Dubai is actively trying to list sukuk on its exchanges and encouraging its state-linked firms to issue trade-able sukuks, but it may be years before supply begins to meet demand.
Another problem is deposit insurance. For bank deposits to be deemed stable they need to be protected by an insurance scheme, but sharia-compliant schemes are rare, partly because government support for domestic banks is considered implicit in many Gulf countries.
Bahrain introduced Islamic deposit insurance in 1993.
In May this year, Qatar said it would develop an Islamic deposit insurance scheme.
In June, Bangladesh said Islamic deposits would be covered under an existing scheme managed by the central bank.
The ﬁrst sukuk to have claimed to be in compliance with Basel III requirements was issued in November 2012 by Abu Dhabi Islamic Bank (ADIB). The issuance was worth USD1bln and classiﬁed as AT1 capital requirements. This issuance generated an overwhelming response with an order book of USD15.5bln (more than 30 times over-subscribed on the initial benchmark size), and carries
a proﬁt rate of 6.375%, the lowest ever coupon for an instrument of this type. This supports proposition that sukuk issuers have an opportunity to tap into the Basel III-compliant sukuk market.
The Islamic Financial Services Board (IFSB) released draft guidelines on capital adequacy for Islamic banks in November 2012 which clariﬁes the use of sukuk as additional capital. As per the IFSB Exposure Draft 15, sukuk issued against assets owned by an Islamic bank may be used by that bank as additional capital to meet regulatory minimum requirements. The minimum maturity of the sukuk is ﬁve years and it should not have step-up features, such as periodic increases in the rate of return, giving an incentive for the issuer to redeem it.
Over the past two years three UAE based Islamic banks such as Abu Dhabi Islamic Bank, Dubai Islamic Bank and Al Hilal Bank have opted for Tier 1 sukuk issuance totalling $2.5 billion. Issuers of these sukuk say that they qualify as Additional Tier 1 (AT1) capital under Basel III.
The ADIB USD1bln sukuk was based on the contract of Mudharabah and is classiﬁed as equity, which therefore does not include principal loss absorption or equity conversion features. Periodic distributions are fully discretionary and non-cumulative. The sukuk is unrated, but will be included in Fitch-eligible capital with a 50% equity credit. It has no maturity date while ADIB can choose to repay the sukuk on certain dates from 2018 if it wishes.
This has signiﬁcant implications in particular for regional banks that deal with both conventional and Islamic ﬁnance. They will have to establish processes to ensure
that the two sets of rules are implemented across two divisions simultaneously. For those banks already specialising in either conventional or Islamic ﬁnance,
the impact is no less signiﬁcant. They will have to comply with new regulatory measures around their liquidity ratios. They will also have to implement strategies for stress testing that allow for complex data to be analysed in order to demonstrate compliance with the Relevant Central Bank’ Basel III directives.
These requirements call for considerable technology change at many banks to ensure that the required ﬁnancial and risk data can be accurately gathered, cleansed, analysed and reported to board members and the regulator in the
Meeting the regulations as they are currently shaped, for Basel III is not a one-time compliance exercise. The requirements will evolve and banks will beneﬁt from taking a long-term view of regulatory compliance. This means developing a framework for implementing consistent compliance practices and implementing a regulatory reporting framework with in-built enterprise-wide risk management tools to ensure ongoing compliance.