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


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

  1. 1. Islamic Financial Services BoardBasel III: Impacts on the IIFS p and the Role of the IFSB Briefing/Workshop on Islamic Liquidity Management & Capital Market 5-6 May 2012 Abdullah Haron Assistant Secretary General
  2. 2. About the IFSBIntroduction• Based in Malaysia officially inaugurated on 3 November 2002 and Malaysia, 2002, 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 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 and end, BCBS, IAIS 2
  3. 3. About the IFSB cont’dObjectives• Develop standards & recommend its implementation• Provide guidance on effective supervision and regulation & develop risk management & disclosure criteria• Establish cooperation with standard international setting bodies & member countries• Enhance & coordinate initiatives to develop instruments and procedures 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 j g y y 3
  4. 4. About the IFSB cont’d 187 members from 43 jurisdictions j By membership type By organisational demarcation Regulatory / Full Member 27 supervisory authorities 53 Inter-governmental Associate Member 26 organisations 8 Financial institutions Observer Member 134 and professional firms 126 Membership as at March 2012 4
  5. 5. Agenda• B k Background: R d Regulatory F l t Framework k• Basel III Framework: An overview• Nature of the regulated IIFS• Impacts of Basel III to IIFS• The Role of the IFSB 5
  6. 6. Background:Regulatory Framework
  7. 7. Background: Regulatory Framework IFSB: capital based on the adaptation of Basel II standardized formula - IFSB: special issues in AAOIFI: CAR - excludes risks borne by capital adequacy on excludes risks borne the PSIA (standard and securitization and real by PSIA supervisory discretion) estate 1988 1996 2006 2010 G30 recommendations 1994 Basel risk management guidelines for derivatives Minimum requirements for trading activities credit risk treatment Capital Capital based 0-8% based on credit risk on credit risk di i k - Standard method equivalents - Int. rating based (also to cover other MR Standard method risks) or Model *3plus As well as op risk and Basel III plus specific risk Market risk charges 7
  8. 8. Background: Regulatory Framework cont’d Supervisory Supervisory review process Action Regulatory Financial Governance and Risk Disclosures Requirements (Capital Adequacy) management { Basic conditions for The IIFS supervisory authority the effective Preconditions P diti functioning of The IIFS sector 8
  9. 9. The IFSB standards It is important to note the notion of balance in the i i t tt t th ti fb l i th 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 risk adequacy, management, corporate governance and disclosure requirements. 9
  10. 10. Development of the IFSB standards Standard Commencement Issuance of preparation Risk management 2003 2005 Capital adequacy 2003 2005 Corporate governance 2004 2006 Transparency & market 2005 2008 discipline Supervisory review process 2005 2008 Note : * corresponds to the date of the 1st meeting of the Working Group 10
  11. 11. Development of the IFSB standards cont’d Standard Commencement Issuance of preparation Special issues in capital 2006 2008 adequacy Governance of investment fund 2006 2008 Governance of Takaful operator G fT k f l t 2006 2009 Sharī`ah governance 2007 2009 Conduct of business 2007 2009 Solvency for Takaful 2008 2010 Liquidity risk 2010 2012 Stress testing 2010 2012 Note : * corresponds to the date of the 1st meeting of the Working Group 11
  12. 12. Development of the IFSB standards cont’d Standard Commencement Issuance of preparation Risk management in Takaful 2011 2013 (ED) Revised capital adequacy 2011 2013 (ED) standard Revised supervisory review 2012 2014 (ED) process Note : * corresponds to the date of the 1st meeting of the Working Group 12
  13. 13. Basel III Framework: An Overview
  14. 14. Basel III Framework: An OverviewThe Global Reform Agenda 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 g Microprudential Basel III: Quantitative Liquidity Standard •Liquidity Coverage Ratio: to survive 1-month stress •Net Stable Funding Ratio: to require longer term funding sources Reform Agenda Systemic Risk •SIFIs Too big too fail SIFIs •Surcharges •Levy and resolution funds •OTC derivatives and central clearing •Non-bank financial institutions Macroprudential Compensation, Cross Border Resolution, Countercyclical Provisioning, Accounting 14
  15. 15. Basel III Framework: An Overview cont’d Capital Leverage Ratio Liquidity Ratio 1a. Increased quantity 2. Enhanced risk coverage 3. Leverage ratio 4. Liquidity ratio •Rise in the overall capital and new capital standards for Leverage ratio Liquidity coverage ratio ratios counterparty credit risk •Includes both on-balance •High quality liquid assets to •Forward looking provisions sheet and adjusted off- off cover a 30 day stress •Additional requirements f for Credit risk Market risk balance sheet assets scenario systemically important institutions •A minimum threshold of 3% Net stable funding ratio Higher capital requirements •Measure of structural •Trading book exposures 1b. Capital buffer liquidity •Securitization exposures •Based on a long term (1 Capital conservation •Resecuritization year) funding requirement Procyclical adjustment Counterparty credit risk Monitoring metrics •CVA risk •Contractual maturity 1c. Increased quality •Wrong way risk mismatch •Move towards central Move Tier 1: Tighter eligibility •Concentration of funding counterparties standards •Available unencumbered assets To be phased out: •Market related monitoring •Capital instruments other tools than common equity •Intangibles •Deferred tax assets •Other items Tier 2: Simplified Tier 3: Abolished 15
  16. 16. Basel III Framework: An Overview cont’dHigher Minimum Capital Adequacy Requirements 14% 13% 13% 13% 13% 2.5% 2.5% 2.5% 2.5% 11.875% 11.75% 2.5% Counter 12% Cyclical Buffer 2.5% 2 5% 11.125% 2.5%% of Risk Weighted Assets 2.5% 2.5% 2.5% 2.5% 10% 1.85% Capital 1.25% Conservation Buffer 0.625% 8% 8% 8% 8% 8% 4% 3.5% 2.5% 2% 2% 2% 2% 2% 2% 2% 2% Other Capital 6% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% Other Tier I 1.5% Capital 1% 4% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% Tier I 2% 4% Common 3.5% 3 5% Equity 2% 2% 0% 2010 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 16
  17. 17. Basel III Framework: An Overview cont’d Timeline 2011 2012 2013 2014 2015 2016 2017 2018 2019Minimum common equity 3.50% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50%capital ratioCapital conservation buffer 0.625% 0 625% 1.25% 1 25% 1.875% 1 875% 2.50% 2 50%Minimum common equity plus 3.50% 4.00% 4.50% 5.125% 5.75% 6.375% 7.00%capital conservation bufferPhase in of deductions fromCET1 (inc. amounts exceeding 20% 40% 60% 80% 100% 100%the limit for DTAs, MSRs andfinancials)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 00% 8.00% 8 00% 8.625% 8 625% 9.25% 9 25% 9.875% 9 875% 10.50% 10 50%conservation bufferCapital instruments that nolonger qualify as non-core Tier Phased out over 10-year horizon beginning 20131 or Tier 2 capital Parallel run 1 January 2013 – 1 January 2017Leverage ratio Supervisory monitoring Migration to Pillar 1 Disclosure starts 1 January 2015 Introduce ObservationLiquidity coverage ratio minimum period begins standard Observation IntroduceNet stable funding ratio period minimum begins standard 17
  18. 18. Basel III Framework: An Overview cont’d Global Capital Capital Impact Framework  Equity capital to increase by 25%- 40%* or more, banks will need to look at ways to optimize the use of capitalIncrease quantity of capital  Additional Tier 1 capital need is almost 60% of the current Tier 1 outstanding capital Better quality of capital  The deferred tax assets change and the new capital instruments will have significant tax g p g implications New leverage ratio  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 Coverage usage of capital Increasing capital charges Counterparty credit riskGlobal Requirements for Liquidity Buffers Liquidity coverage ratio Net Stable funding ratio Monitoring liquidity risk 18
  19. 19. Basel III Framework: An Overview cont’d Global Capital FrameworkIncrease quantity of capital Better quality of capital New leverage ratio Risk Coverage Increasing capital charges Counterparty credit risk Liquidity ImpactGlobal Requirements for  Additional 40% requirement for liquidity over the liquidity buffer held currently Liquidity Buffers  Require an additional increase of 10 – 15% of stable funding over the currently available Liquidity coverage ratio stable funding  Liquidity risk, stress testing and reporting pose challenges for many banks risk Net Stable funding ratio  Impact on income as bank invests in more liquid investments and curtailed loans maturity to match available stable funding Monitoring liquidity risk  Increased cost of liquid funds as demand increases and high interest costs of holding stable funds 19
  20. 20. Basel III Framework: An Overview cont’d Global Capital FrameworkIncrease quantity of capital Implementation issues and Operational costs Better quality of capital  Additional costs of implementation of systems for Basel III compliance is estimated to be between 30 – 50% of outlays for Basel II implementation New leverage ratio  Interdependence and complexity in designing systems to capture granular data for modeling and stress testing  Drafting and incorporating new risk management policies and processes Risk Coverage  Increased operational costs of monitoring reporting and being compliant by 2012 monitoring, Increasing capital charges Strategic implications Counterparty credit risk  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 c a ges and restrictions which can be up to a factor o 10 for c eas g cap ta charges a d est ct o s c ca acto of 0 o securitizationGlobal Requirements for  Pressure to increase lending spreads leading to possible loss of valuable Liquidity Buffers customers  Risk of falling below shareholder ROE expectation Liquidity coverage ratio  Growth can take a backseat with increased capital, liquidity and leverage requirement Net Stable funding ratio Monitoring liquidity risk 20
  21. 21. Nature of the regulated IIFS
  22. 22. Stylised Balance Sheet of an IIFS ASSETS LIABILITIES q Cash & cash equivalents Current accounts Sales receivables Other liabilities Investment in securities Investment in leased assets Equity of Profit Sharing Investment Accounts (PSIA) Investment in real estate Profit Sharing Investment Accounts Equity investment in joint ventures (PSIA) Equity investment in capital ventures Profit equalization reserve Inventories Investment risk reserve Other assets Fixed assets Owners’ Equity 22
  23. 23. Risks: IIFS vis-à-vis conventional banks• 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. one stop shopping”• 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. receivables) as securities, which represent a hi h i bl ) ii hi h high percentage of total assets, in order to take the risk off their balance sheet. 23
  24. 24. Risks: IIFS vis-à-vis conventional banks cont’d Type of Risks T f Ri k Definition D fi iti Equity Investment The risk arising from entering into a partnership for the Risk purpose of undertaking or participating in a particular financing or general business activity as d fi i lb i ti it described i th ib d in the contract, and in which the provider of finance shares in the business risk. This risk is relevant under Muḍārabah a d us ā a a co ac s and Mushārakah contracts. 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 pressure Commercial Risk 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 to t i it f d t retain its fund providers and di id d dissuade th d them f from withdrawing their funds. Sharī`ah Risk arises from the IIFS’ failure to comply with the Noncompliance Risk shariah rules and principles principles. 24
  25. 25. Risks: IIFS vis-à-vis conventional banks cont’dOverall,Overall IIFS have been well capitalised since they started their operations. Tier 1 and total capital requirements currently stand at 8% and 12% respectively.• IIFS have non-financial assets in their balance sheets –Capital charges with respect t i C it l h ith t to inventory risk t i k• Majority of Islamic banks assess their credit risks by applying the standardised approach –Lack of data and smaller sample size 25
  26. 26. Risks: IIFS vis-à-vis conventional banks cont’d• 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.• The IIFS could use Investment Risk Reserve (IRR) and Profit Equalisation Reserve ( q (PER) to p ) protect the PSIA investors from financial risks.• The IIFS will bear losses for the risks arising from negligence or misconduct on i part i managing the PSIA li i d its in i h – operational risk. 26
  27. 27. Impact of Basel III on IIFS
  28. 28. Impacts of Basel III to IIFS Global Capital Current Scenario Framework Basel III approaches to enhance the quality of capital. The enhancement changes the Increase quantity of capital demographic of debt based capital to one of equity. IIFS already have a higher proportion of equity as capital. Better quality of capital 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 New leverage ratio Profit Equalisation Reserve. Capital Impact Risk Coverage Require IIFS to hold much more of the best form of capital while some of the existing capital Increasing capital charges will cease to count. Deductions from capital will increasingly be made from core tier 1. Counterparty credit risk 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. p A large part of the IIFS’ profits over the next decade will go into the new standing funds.Global Requirements for Liquidity Buffers Leverage Ratio Liquidity coverage ratio PSIA cannot be included in additional Tier1 capital because they do not meet the criteria set out by the Basel III. Net Stable funding ratio Assets financed by the PSIAs are excluded from the exposure measure because the PSIAs are not included in the Tier 1 capital. Monitoring liquidity risk 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
  29. 29. Impacts of Basel III to IIFS cont’d Global Capital Framework Increase quantity of capital Better quality of capital New leverage ratio Risk Coverage Current Scenario Increasing capital charges Liquidity 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 Counterparty credit risk 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 ) g IIFS to domestic markets.Global Requirements for Liquidity Buffers Liquidity Requirement Impact Liquidity coverage ratio Highly rated Sukuk are considered to meet the stock liquidity requirements. Th need t maintain a stock of assets that can be turned into cash requires th i d t The d to i t i t k f t th t b t di t h i the industry Net Stable funding ratio stakeholders to collaborate with one another. Treatment of PSIA and other sources of funds with respect to the run-off in the calculation of Monitoring liquidity risk liquidity ratio. The role of rating agencies will play a role in determining sukuk rating. 29
  30. 30. Impacts of Basel III to IIFS cont’d Global Capital Framework Tier 1 is already Increase quantity of capital the case of IIFS Better quality of capital Tier 3 is limited in New leverage ratio IIFS Risk Coverage PER and IRR play Increasing capital charges similar role in forward Counterparty credit risk looking provision and Leverage is counter cyclical capital already low in IIFSGlobal Requirements for Liquidity Buffers Liquidity coverage ratio Shari`ah compliant Net Stable funding ratio Instruments I t t Monitoring liquidity risk Establishment of the IILM 30
  31. 31. The Role of the IFSB
  32. 32. 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 1: Raise the quality of capital Task 1: Introduce a leverage ratio Task 2: Improve the coverage of risk Task 2: Introduce measures to raise capital in good ti d times so th t they can be d that th b drawn d down i in Task 3: Require much higher levels of capital to periods of stress to reduce procyclicality absorb the types of losses associated with the crisis Task 3: Require globally systemic banks to have additional loss absorbanccyy Task 4 Introduce a global li idit standard t T k 4: I t d l b l liquidity t d d to supplement the capital regulation Task 5: Introduce stronger supervision, risk management and disclosure standards
  33. 33. The Role of the IFSB cont’dThe 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 into authorities, consideration the specificities of IIFS and complementing relevant existing and emerging international standards and best practices practices. –The stress testing aims to provide a set of guiding p principles intended to complement the existing p p g international stress testing framework. 33
  34. 34. The Role of the IFSB cont’dThe IFSB has formed a working group last year aiming year, 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 major Sh i’ h compliant products; j Shari’ah li t d t –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 capital through innovative Shari’ah compliant structures; and –Promote robust risk management. Promote management 34
  35. 35. The Role of the IFSB cont’dThe IFSB is working on revising the IFSB-5 in order to IFSB 5 ensure that the review process covering IIFS will be consistent with those for conventional institutions and relevant 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 supervisory review process such as that of the BCBS and EBA. 35
  36. 36. ThankTh k you for your attention f tt tiabdullah@ifsb.orgReferences1. 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, Introduction3 S Srivastava “Introduction to Basel III , IFSB Seminar on Risk Mitigation and Enhancing Financial III” Stability in Islamic Finance: Contingent Capital and Takaful, Jan 2011