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Saturday, 14 July 2007

Synchronising Islamic banking with Basel II


The introduction of Basel II provisions, the new international regimen on capital adequacy and risk management for banks, is forcing banks in the Middle East to set more stringent targets in managing their risks. The new framework would lead Middle East’s banks to greater operational efficiency, improved capital allocation and greater shareholder value through the use of better risk models and reporting capabilities. This may succeed in bringing in less volatile profits, says the head of the Basel committee on bank supervision Nout Wellink. Basel II had also set standards for recognising the transfer of risk by banks in securitisation and credit derivatives structures. Banks have steadily moved away from a traditional business “buy and hold” model, under which they extended loans to borrowers and kept them as assets on their balance sheets to an “originate and distribute” approach which entails passing on the risk of lending to other parties. Basel II “sets a boundary between the point at which a firm transfers risk and actually retains the risk”, Wellink says. In 2004, the Basel Committee on Banking Supervision, an international panel of bankers and regulators, introduced a risk-sensitive capital adequacy framework that comes into force in Europe at the end of the year. In the United States it is due to be implemented in 2008 but some banks overseas have already started their own test runs. Bahrain wants its banks to comply with Basel II by 2008, as does Saudi Arabia. Qatar is already on course. A consultation paper issued by the Central Bank of Bahrain (CBB) contains the proposed policy for implementing Basel II requirements related to Pillar One, which deals with minimum capital requirements for banks. The proposals contained in the consultation paper cover revised requirements concerning credit and market risk, consolidation and deduction issues and new capital requirements for operational risk. They follow from extensive dialogue, which has been taking place between the CBB and Bahrain’s banks over the past one year. A key highlight of the CBB proposals includes a new risk-focused approach to credit. The CBB wants to review the current industry-wide 12 per cent trigger (and 12.5 per cent target) minimum capital adequacy requirements and to set individual minimum trigger and target capital ratios for each bank based on supervisory reviews of all locally incorporated banks which will take place this year. There is also greater recognition of credit risk mitigation in Basel II. The CBB proposals allow the increased use of external credit assessments for risk weightings of banks’ assets. Banks should also note new risk weighting arrangements for past due loans, low-rated sovereigns and holding of securitisation tranches below investment grade. Although Islamic products are not explicitly mentioned in Basel II, given the importance of Islamic banking in Bahrain, the CBB has adopted a comprehensive framework, which includes the guidelines of the Islamic Financial Services Board (IFSB) for the capital treatment of products such as Murabaha among others. Further consultations will follow on Pillar Two, which deals with banking supervision, and Pillar Three, which aims to improve market discipline by requiring greater disclosure of banks’ financial status and their internal risk management procedures. Be that as it may the fact remains that Arab nations have not yet figured out yet how Islamic banking products should be treated under Basel II. Under Sharia law, banks cannot engage in transactions that could be deemed speculative, pay interest and involve contractual uncertainty. Last December, the Malaysia-based Islamic Financial Services Board (IFSB), an Islamic finance industry body, issued a paper called Capital Adequacy Standard for Institutions (other than Insurance Institutions) offering only Islamic Financial Services, which offers banks and monetary authorities a template for applying Basel II to sharia-compliant products. The IFSB paper delineates how Sharia-based transactions should be defined, measured and treated under Basel II. The guidelines cover minimum capital adequacy requirements based on the standardised approach for credit risk and the basic indicator approach for operational risk, and the measurement methods for market risk as outlined in the 1996 Market Risk Amendment. The IFSB’s guidelines, however, are not binding. Just as with Basel’s rules, it comes down to how the national regulators apply the framework. There’ll be differences between different countries, and ultimately it is the central banks that decide the exact regulatory discretions that need to be applied. The IFSC guidelines can serve as the basis on which Arab nations can band together and bring clarity to how each of the Islamic banking products should function under Basel II. A high-power expert committee needs to be set up at the GCC level to deal specifically with the issue of synchronising Islamic banking with Basel II. - (GW,14 July 07)

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Alfalah Consulting - KL: www.alfalahconsulting.com 
Islamic finance consultant: www.ahmad-sanusi-husain.com 
Islamic Investment Malaysia: www.islamic-invest-malaysia.com

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