Islamic Banking and Financial Regulation

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Table of Contents
Introduction ............................................................................................................................................................ 3

Basel III ..................................................................................................................................................................... 4

Basel III capital requirements ..................................................................................................................... 5

Islamic Banking and Banking regulations ................................................................................................... 6

Basel III impact on Islamic Banks .............................................................................................................. 7

Critical review of IFSB standards ................................................................................................................... 8

IFSB 15 ................................................................................................................................................................. 9

Basel III- SUKUK ................................................................................................................................................. 10

Maqasid ul Shariah and Perpetual Sukuk ............................................................................................ 10

References ............................................................................................................................................................ 11

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Introduction
Islamic financial institutions were established four decades ago as against conventional
financial institutions mainly to provide Shariah compatible investment, financing, and
trading opportunities. A Study from the International Monetary Fund (IMF) specifies that
Islamic banking gives the impression to be a counterpart of the conventional banking system,
not a substitute. During its short history, the growth in the nascent banking industry has
been impressive. One of the main functions of financial institutions is to effectively manage
risks that arise in financial transactions.

Risk is a natural element of business and community life. It is a condition that raises the
chance of losses or gains and the uncertainties regarding potential events which could
manipulate the success of financial institutions (Ahmed and Khan 2012). Well-established
risk management practices assist banks to reduce their exposure to risks. The key issue in
Islamic principles regarding banking system is the prohibition of Riba, The Quran states
Believers! Do not consume riba, doubling and redoubling

Some risks are common to both Islamic banks and conventional banks such as credit risk,
market risk, operational risk and liquidity risk but some risks are unique to Islamic banks
only such as displaced commercial risk and Shariah compliance risk. However both have to
do risk management according to the risk they face (Ahmed and Khan 2012).

Over the past few decades, the Islamic financial industry has expanded exponentially at the
global horizon. The essence of Islamic banking is being free of interest. The conventional
system containing interest as its flagship creates an inequitable distribution of income in the
society.

Whereas supervision is the practice intended to direct financial institutions on to the path
that ensures proper application of rules and standards. Commercial banks and other
financial intermediaries are monitored by central banks and financial authorities, because of
their important role in todays economy. Together, central banks and financial authorities
oversee the payment system, protection of public interest, price stability, smooth flow of
funds and pursue the stability and resilience of banks (Padoa-Schioppa 1999).

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The financial crisis of 2008 is the outcome of financial engineering which results into
excessive risk taking by financial institutions without the adequate backup of capital1. The
adverse impact of financial crisis was felt by developed and many developing countries
(Reinhart and Rogoff 2008). In response to this financial crisis, the international regulations
became more conservative, stringent and capital based. Basel III has emerged in response to
the deficiencies in financial regulations. Its objective is to strengthen bank capital
requirements by focusing on the quality and quantity of capital with the application of
addition of Capital Buffers (Basel Committee on Banking Supervision 2011).

Banks all across the world has started to implement Basel III regulations. To meet these
regulations, there is a need to raise capital either with the help of capital market 2 or through
retained earnings. Developed countries have efficient capital market so; they can raise
capital to meet Basel III capital requirements (Demirguc Kunt 2004). Several studies in
literature have highlighted the adverse effect of the imposition of Basel III on developing
countries. As these accords were designed for the United States (US) and European Union
(EU) financial institution and there implementation is difficult in emerging and developing
countries (Brooke Masters3).

Basel III
The Bank for International Settlements (BIS), headquartered in Switzerland, is an
international organization which promotes international monetary and financial
cooperation and serves as a bank to central banks. Among its many goals is the promotion of
monetary and financial stability in the banking sector across the globe. For this cause, a
special committee was assembled in 1974 to develop solutions for supervisory issues and
improve the quality of banking supervision worldwide, called the Basel Committee on
Banking Supervision (Basel Committee on Banking Supervision 2006)

Their work resulted in the formulation of Basel Accords, some of the most influential
agreements in modern international finance. Drafted in 1988 and 2004, Basel I and II have

1
Capital refers to the financial resources that are available for use. The difference between the value of a
banks assets and its liabilities is called bank capital that represents the net worth of the bank.
2
Capital Markets are the financial markets for buying and selling equity and debt instruments.
3
Brooke Masters is a Chief regulation correspondent at Financial Times
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ushered in a new era of international banking cooperation. Both accords have helped
harmonize banking supervision, regulation and capital adequacy standards (Balin 2008).
Basel II was shortly accompanied by Basel III in 2010.

The BCBS was proposed Basel III in September, 2010 named as, A Global Regulatory
Framework for More Resilient Banks and Banking System. Basel III reflects attempts of BCBS
to apply lessons learned from the financial crisis to the existing framework of banking
regulation. The primary purpose of Basel III is to improve the ability of banks to absorb asset
losses without affecting the rest of the economy. In aspect of capital regulation, Basel III
emphasizes mainly on the quantity and quality of capital held by banks. The main highlighted
regulations in Basel III are Liquidity risk, Leverage ratios, increased capital requirement and
top most the Capital buffers; Capital Conservation Buffer and Counter Cyclic Buffer. Basel
Committee has required setting these two buffers in order to prevent against a financial
collapse. The new proposals of Basel III include countercyclical capital buffers with range of
0% to 2.5% of Risk Weighted Assets (RWA) for the sake of pro-cyclicality reduction. 2.5% of
RWA is allocated for Capital Conservation Buffer which banks have to maintain in good
economic conditions and utilize in recession period (Basel Committee on Banking
Supervision 2011).

Basel III capital requirements

Where Basel II distinctively classified capital funds under Tier 1, Tier 2 and Tier 3, and total
regulatory capital was to be maintained at a minimum of 8% of risk-weighted assets (RWA).
Basel III has abolished the tier 3 capital class enforcing capital to be kept either from Tier 1
or Tier 2. From 4% for Tier 1 and tier 2 under Basel II the components have been modified
to Tier 1 capital being 6% and Tier 2 capital being 2% under Basel III. Moreover the Common
Equity Tier 1 (CET1) has been increased from 2% to 4.5% to enhance the capital quality as
under Basel III.

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The Capital Conservation Buffer CCB of 2.5% is expected to be realized by 2019. This buffer
is proponent of causing an increase in total regulatory capital matching 10.5% contrary to
the 8% of RWA as under Basel II. These changes are displayed graphically in Figure 1.

Source: (Sairally et al. 2013)

Whilst taking the difference between going concern and gone concern capital in the new
Accord, the losses are to be deducted from Common Equity Tier 1 (CET1); then from
Additional Tier 1 capital; if any further losses are remaining they will be absorbed by Tier 2
capital ultimately. Here the principle is that the losses are to be bear by, depositors and
general creditors in the end that is after equity holders in case of liquidation. This procedure
supports the overall aim of keeping adequate capital to bear the loss in the times of financial
distress. The Banks need to issue such capital instruments that are long term and equity like
or at least convertible to common equity or have mandatory write down features (Basel
Committee on Banking Supervision 2011). The main feature of Basel III that is worth
discussing is its capital buffers with respect to Islamic financial institutions, in general and
CCB in particular, reason being their recognition as a key challenge in the eyes of IFSB, as per
the Islamic Financial Services Industry Stability Report 2013 (IFSB 2013) .

Islamic Banking and Banking regulations

The increased capital requirements and the redefined criteria introduced under Basel III has
raised some key issues with respect to the Islamic Banking. Whether the capital instruments

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to raise the required capital acceptable under Shariah principles, and all the while capable
to make IFIs resilient to financial stress.

Basel III impact on Islamic Banks

Islamic and conventional banks are way different in nature of their transactions and
investment activities. Islamic banks capital structure is not the same as of conventional
banks. Islamic banks operate their banking business in compliance with Shariah. Payment
and receipt of interest is prohibited in Shariah so Islamic banks cannot pay or receive any
interest on their financial instruments (Harzi 2012). In this aspect, implementation of Basel
III is also a major challenge for Islamic banks as the standards under Basel III are designed
for conventional banks but Islamic banks must also comply (Ahmed et al. 2013). Islamic
Banks are encouraging the nature of Basel III CCB regulation as it will make banking sector
more resilient. But the challenging global environment of commercial banks has grabbed the
attention of policy makers and scholars towards Islamic banking as a viable alternative-
banking model (Beck et al. 2013). Islamic banks seem to adjust their own capital buffers in
an effort to more accurately reflect their own risk outlooks (Daher 2014).

Islamic banks are generally well capitalized because most of their capital is based on Tier-1
and only small portion of Tier-2 capital (Hassan and Bashir 2003). So, it is easy for Islamic
banks to meet the Basel III capital requirements comfortably (Rougeaux and Annadif 2013).
Since, Islamic banks that are hardly meeting the minimum capital requirement may face
some challenges while raising capital for CCB because investment (mudarabah) accounts do
not count as common equity because these accounts are treated as banks liability not assets.
Islamic banks maintain profit equalization reserves to smooth out payments to investment
mudarabah depositors so that in case of losses, bank can still receive their profit share. Since,
profit equalization reserve is for the benefit of investment mudarabah depositors so; it
cannot be counted as retained earnings. Now Islamic banks could argue that if profit
equalization reserves are not allowed to count as retained earnings then they could count it
for capital conservation purposes (Ahmed et al. 2013). The objective of Capital Conservation
Buffer is different from the profit equalization reserve and the investment risk reserve. The
reason is that these two reserves are compounded from the profit of the investment account

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holders, not from the investment of shareholders. So, if banks want to count these reserves
as CCB then shareholders should transfer their own profit in these reserves (Harzi 2012).

Islamic Banks, they are also bound to follow Basel III requirements just like conventional
banks as discussed earlier. Islamic banks also have to raise capital to meet the requirement
of Capital Conservation Buffer. Conservative business models of Islamic banks forbid interest
bearing instruments so; they may find it difficult to raise capital. Surprisingly, Islamic banks
are well capitalized than conventional banks (Hassan and Bashir 2003; Ahmed et al. 2013)
so, fulfilling CCB requirement is manageable. Since, profit equalization reserve and
investment risk reserve are enough to absorb losses so; Islamic banks should be given an
opportunity to adjust their own capital buffers according to their risk profile (Daher 2014).
Islamic banks are private limited companies so they will manage capital with the help of
retained earnings, asset management and investment management companies to fulfill the
CCB requirement. Islamic banks are also diversifying their portfolio into government
securities (Montgomery 2005). It will help in blocking less capital in the form of CCB but at
the same time will discourage growth prospects of banking sector. As a whole, Islamic banks
are at beneficial place than the conventional banks in implementation of the Basel III capital
and buffer regulations as the Islamic banks are Shariah-Compliant that mostly has Tier 1
capital as major source of funding (Hassan and Bashir 2003).

Coping up with Basel III, Islamic Financial Services Board (IFSB) have provided revised
standards for the capital requirements as discussed below.

Critical review of IFSB standards

The IFSB is the most important regulatory authority with internationally recognized
standard-setting procedures. With the mission to promote Islamic financial services and
provide standards aligned with Shariah principles it is operational since 10th March, 2003 in
Kuala-Lumpur, Malaysia. Following standards dealt with the Basel III capital requirements
in the light of Shariah.

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IFSB 15
Keeping in view the uniqueness of Islamic financial institutions from their conservative
counter parts in products and operations Basel III requirement need further elaboration. The
Islamic Financial Services Board (IFSB) published IFSB ED-15 Exposure Draft 15 in
December 2013 for implementation of a framework for capital adequacy and liquidity
requirements to cater for the given uniqueness of IFIs. The IFSBs ED-15 provides
comprehensive principles not only to govern institutions offering Islamic financial services,
but also to assist the regulatory and supervisory authorities, and puts forward monitoring
tools for liquidity risk assessment and management.

The IFSB-ED15 is an amendment to its previous two documents of IFSB-2 and IFSB-7; IFSBs
standards on capital adequacy. IFSB-2 provided the capital requirements for IFIs in general
whereas IFSB-7 accommodated capital adequacy requirements for securitizations, Sukuk,
and real-estate investments. IFSB-ED15 as its predecessors entails guidelines for the
classification of regulatory capital components i.e. tier 1 and tier 2. It defines common-equity
as the tier-1 core capital and preferred-stock as the AT1 as is done by Basel III. However
preferred stock is recognized as Shariah-complaint product only in a few countries such as
Malaysia (Sairally et al. 2013).

Furthermore, in IFSB-ED 15 perpetual musharakah-sukuk is recognized as AT1 capital,

whereas mudharabah and wakalah-sukuk having maturity of 5-years or more are
considered to be a component of tier 2 capital in a given IFI. Meanwhile other types of sukuk
can be classified as the component of Tier 2 capital or AT1 given they meet the requirements
dictated under IFSB-ED15 for each case. In summary, the IFSB-15 recognizes sukuk as the
financial instrument capable of meeting Basel III requirements. However, despite the
elaborate guiding principles on the capital requirements this document fall short on
providing assistance on the role of Displaced Commercial Risk and its reserves in capital
buffer calculations. It gives plenty of room to the bankers to charge profit equalization
reserves as AT1 whilst catering for CCB.

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Basel III- SUKUK
Basel III and IFSB-ED15 has paved the way for sukuk to be used by IFIs and other IFIs as an
alternative instrument for compliance with regulatory requirements. Nine issuances of such
instruments has been recorded since January, 2013 when Basel III initiated rounding to a
total of more than $4.93 billion (Kuwait News Agency (KUNA) 2014)

Abu Dhabi Islamic Bank (ADIB) in November 2012, issued the first Basel III- compliant Sukuk
even before the official initiation of the Accord. ADIB issued perpetual mudharabah-sukuk
to raise AT1 capital. Shortly after ADIB, Dubai Islamic Bank (DIB) took the second Basel III-
compliant sukuk to the market in March 2013 for their AT1. By the end of 2013 and
beginning of 2014, three further issuances occurred in Saudi Arabia, from National
Commercial Bank (NCB), Saudi British Bank (SAAB) and Saudi Hollandi Bank (SHB). These
issuances occurred to increase tier 2 capital, unlike, ADIB and DIB.

The success of these Basel III compliant sukuk reached South-east Asia that followed
issuance of sukuk by Maybank Islamic, RHB Islamic, Public Islamic (murabahah structure)
and AmIslamic Bank to raise tier 2 capital.

Maqasid ul Shariah and Perpetual Sukuk

Imam Al Ghazali says The objective of the Sharia is to promote the well-being of all
mankind, which lies in safeguarding their faith (dn), their human self (nafs), their intellect
(aql), their posterity (nasl) and their wealth (ml). Whatever ensures the safeguard of these
five serves public interest and is desirable (Chapra 2000). In general, Shariah is grounded
on the benefits realized by the individuals and community and whereas its laws are there to
protect these benefits all the while facilitate enhancement of the condition of living. The
foremost maqsd of Shariah rests upon the foundations of compassion and enlightenment,
aiming to eradicate prejudice, establish just system and curtail privation. This promotes
cooperation, harmony and mutual support within family, community and society, giving
realization to maslaha that is the universal objective of the Shariah as per Islamic scholars.
Basically, maslaha is the quest of benefit and the eradication of harm in the guidance of
Shariah (AbdelKader 2003)

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In case of the Sukuk and perpetual sukuk in particular the market developments have not
realized any fruit for the public at large, since general public dont have essential access to
sukuk. However an argument can be put forward that sovereign sukuk deployed to finance
big development projects can benefit general public in spirit. Limited access to the capital
market entail disadvantage to both the issuer and the general public. Where general public
cannot enjoy the profits from investments in the capital market, the issuers also are unable
to reduce risks through a wide investor base. Here it is important to reiterate that the
circulation of wealth, and means of wealth creation, accessible to only wealthy elites is
considered illicit in Islam; the Holy Quran says so that the wealth does not circulate only
among your rich folk (Al-Hashar 59:7).

Aiming at financial inclusion can help achieve the maqasd al Shariah of maslaha, to repel
harm and benefit the masses. Since early 2000s the concept of Financial-inclusion has gained
immense significance. It refers to the delivery of financial-intermediation services to low-
income units at considerably low costs. In the past decade, financial inclusion has evolved as
a four dimensional concept; institutionally and financially sustainable financial institutions,
stable institutions prudentially regulated by supervisors, ease in access to finance, and
competition to bring alternatives to prospective customers (Beck and Demirg-Kunt 2008).

The sukuk market can be tapped into for achieving the objective of maslaha by incorporating
features of financial inclusion through expanding the distributional aspects of these sukuk
to widen the investor base. This approach is comparatively simple as any sukuk can be
retailed. Since general public are less sophisticated and much literate of financial jargons, the
contracts must be made simple and straight forward. For this venture to be taken up by the
public, government or third party guarantees will be required to calm the risk averse
investors (Sairally et al. 2013).

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