Chapter 14
Measuring Risk for Capital Adequacy: The Issue of Profit-Sharing Investment Accounts
1. INTRODUCTION
This chapter is concerned with the rationales for the regulation of capital adequacy and their applicability to Islamic banks. Section 2 examines the rationales for capital adequacy of conventional banks. Section 3 analyses the extent to which these rationales are applicable to Islamic banks, and examines the issues that arise in that context. Section 4 considers the links between capital adequacy and risk management in the context of the Basel Committee on Banking Supervision’s (BCBS) Revised Framework (Basel Committee on Banking Supervision, 2004) and the subsequent BCBS publications on the subject in the context of what is generally known as Basel III. Section 5 sets out some concluding remarks.
2. WHY CAPITAL ADEQUACY?
All organisations that incur liabilities require some form of capital backing in order to support those liabilities—that is, for the purpose of creditor protection. In the nonprofit or government sectors, this backing may be in the form of a guarantee. For commercial firms, market forces operate so that undercapitalised firms find it hard to obtain credit. In many jurisdictions (but not, for example, in the United Kingdom), commercial firms that are limited companies are also required by law to build up a “statutory reserve” out of retained profits for creditor protection purposes, and are subject to dividend restraints until they have done so. Also, company law typically prevents limited companies from paying dividends out of capital and out of certain reserves (such as revaluation reserves) that are not formed out of retained profits. But outside of the financial sector, the matter of capital adequacy is left essentially to market forces; in other words, undercapitalised firms encounter difficulties in obtaining credit, and so on. In fact, the term “capital adequacy” is not normally used in connection with nonfinancial firms; instead, the more general term “solvency” is used to refer to the ability to service liabilities. In contrast, capital adequacy is seen as a major issue for financial sector firms, and its use implies that the matter is not essentially left to market forces as in the case of nonfinancial firms. Why is this?
The literature on capital adequacy gives the rationales for its regulation as follows:
- Financial sector firms, and especially banks and insurance companies, are subject to various forms of regulation that impede the normal operation of market forces. In the case of banks, such regulation has as a major objective the mitigation of the systemic risk of contagious collapse, whereby one firm’s failure triggers a series of others, thus imposing social costs. Banks are particularly vulnerable to contagious collapse because of the liquid nature of their liabilities combined with the illiquid nature of their assets and the magnitude of financial distress costs. But the default of an investment firm may also impose social costs, especially if it is part of a bank (in a universal banking regime) so that the bank’s capital stands behind its investment operations (Dale 1996).
- Regulation may include a deposit guarantee system, which reduces incentives for depositors to impose market discipline on banks with regard to their risk taking. This leads to the deposits being underpriced in terms of their interest rates, and provides incentives for banks to hold less capital than would otherwise be required by market forces to support the risks to which they expose their depositors’ funds, or alternatively to take on more deposits than is justified by their capital base (a moral hazard problem).
2.1 Basel I
For these reasons, capital adequacy has long been a preoccupation of banking supervisors. The Basel Committee on Banking Supervision (BCBS), part of the Bank for International Settlements, issued its first Capital Accord (“Basel I”) in 1988. The Capital Accord was based on a two-pronged approach to capital adequacy. The first prong was a measure of risk in terms of risk weightings applied to assets, the only risk to be considered being credit risk. The second prong was a measure of the regulatory capital available to support the risk, divided into Tier 1 and Tier 2 capital. (A Tier 3 was subsequently introduced in the 1996 Amendment to the Capital Accord to Incorporate Market Risks.) As well as equity capital, regulatory capital included amounts classified as general provisions and also (subject to limitations) subordinated debt. The latter is widely used by banks in some countries (especially the United States) where its pricing plays a role in market discipline. The ratio of regulatory capital to the amount of risk-weighted assets is the capital adequacy ratio (CAR). The aim of the 1988 Capital Accord (Basel I) was to indicate a minimum recommended level of regulatory capital, with a CAR of 8 percent.
Being intended as a minimum, this level did not aim to represent the optimum economic level of capital for a bank, capital being a residual claim that “trades off effects on liquidity creation, costs of bank [financial] distress, and the ability to force borrower repayment” (Diamond and Rajan 2000). Well-capitalised banks would tend to hold more than this minimum, especially as the Basel I Accord covered neither market risk nor operational risk. An amendment to the 1988 Accord was issued in 1996, dealing with the various forms of market risk: interest rate risk, equity position risk, foreign exchange risk, commodities (price) risk, and options. The target CAR remained at 8 percent.
During the 1990s, however, it became increasingly recognised that on the one hand the approach of Basel I to the measurement of credit risk was both over-simplistic and rigid, while on the other hand some account needed to be taken of operational risk. Moreover, the approach of banking supervisors to the regulation of capital adequacy and other matters should take account of the bank’s own risk measurement and management skills (the so-called risk-based approach to supervision). With regard to credit risk, the system of risk weights called for considerable fine-tuning and elaboration to take account of various risk mitigants. Banks with the necessary capabilities should be able to use their own credit risk ratings in calculating their risk weights, rather than using the standardised weightings laid down in the Capital Accord. Other banks should be able to use credit ratings issued by approved external credit assessment institutions (ECAIs) such as Moody’s, Standard & Poors, and Fitch, when available, in arriving at credit risk weightings for their financial assets.
2.2 Basel II
These considerations led to the preparation by the BCBS of a Revised Framework for capital adequacy, commonly referred to as Basel II, of which a final version was issued in June 2004, covering credit risk and operational risk. The Basel II document is long and complex, and its preparation involved considerable controversy. In addition to capital adequacy (its first “Pillar”), the Accord deals with the principles of supervisory review (Pillar 2) and market discipline (Pillar 3). The “fine-tuning” approach adopted in Pillar 1 has been criticised on a number of grounds. One criticism is that as a result of the fine-tuning, the distinction between the regulatory capital requirement (supposedly a minimum) and a bank’s economic or “optimum” level of capital is no longer clear. Another criticism is the importance given to ECAI credit ratings in the “standardised” approach, although such credit ratings are confined to a relatively small proportion of credit risks, especially from an international perspective (Cornford 2003 and 2004).
One important issue was the combining of banking with securities operations in major European banks (so-called universal banks). Different capital adequacy criteria apply to banking and securities operations. This led to the adoption of a “banking book–trading book” approach in the E.U. Capital Adequacy Directive 1993. Here, the securities activities as defined by the “trading book” are subject to a capital adequacy regime that is separate from the banking business as defined by the “banking book.” One problem with this dichotomy is apparent when it is recognised that hedges of banking book items (such as hedges of foreign currency risk on financial assets) are typically handled through the bank’s treasury as part of its trading activities that belong to the “trading book.”
2.3 Basel III
Following the financial and economic crisis that began in 2007, the BCBS again revised its capital adequacy guidelines. The main revisions to these concerned:
- Redefining the components of regulatory capital (including some new types of convertible and subordinated capital instruments and the criteria for their being included in regulatory capital, based on their degree of loss absorbency).
- Redefining the tiers of capital; eliminating Tier 3 and distinguishing between Common Equity Tier 1, Additional Tier 1, and Tier 2. Tier 1 instruments have loss absorbency characteristics such that they absorb losses while the bank is still a “going concern,” while Tier 2 instruments absorb losses when the bank is in liquidation—hence the term “gone concern capital.”
- Increasing the requirement for common equity, including a “capital conservation buffer,” to a total of 6 percent.
- Introducing a “countercyclical capital buffer” for the macroprudential purpose of mitigating both credit bubbles in times of economic expansion and credit crunches in times of contraction.
- Introducing a “leverage ratio’”—a minimum percentage of Tier 1 capital to total unweighted exposures—intended to prevent low risk weightings of assets allowing banks to take on excessive levels of assets in relation to capital.
For reasons that will be explained below, the leverage ratio just mentioned has relevance for Islamic banks, although as a matter of principle they have no interest-bearing liabilities.
3. APPLICATION TO ISLAMIC BANKS
Typically, Islamic banks are somewhat similar to universal banks, in that they combine banking operations with trading operations, not necessarily in securities but in commodities and other nonfinancial assets—for example, by means of salam and istisna’a contracts. However, they differ significantly in that they typically mobilise funds in the form, not of interest-bearing deposits, but of profit-sharing investment accounts (PSIA). This is relevant to the specification of the CAR: Are PSIA part of the bank’s risk-bearing capital (numerator of the CAR), and are the assets financed by PSIA part of the bank’s assets that, on a risk-weighted basis, are included in the denominator of the CAR? This issue is discussed further in Subsections 3.1–3.3.
The calculation of risk-weighted assets is also affected by two factors:
These are technical, rather than conceptual, issues that are dealt with in the Explanatory Note which is part of the IFSB Standard No. 2 on Capital Adequacy,1 and will not be explored further here, except for asset-side mudarabah and musharakah, which are discussed in Subsection 3.5 below.
There are other, systemic, sources of difference that affect liquidity risk. These sources include the lack, in many countries, of Shari’ah-compliant cash equivalents that offer a return to the holder, of a Shari’ah-compliant interbank market, and of a Shari’ah-compliant lender of last resort facility. The effect of this on capital adequacy is a matter for Pillar 2 of the Revised Framework, and will be discussed in Section 4.
On a more fundamental level, one may ask to what extent Islamic banks share those characteristics of conventional banks mentioned above, which raises two questions: the first regarding capital adequacy, and the second about whether they have other, different, characteristics with capital adequacy implications:
3.1 Islamic Banks, Financial Distress, and Systemic Risk
Because PSIA juristically are not debt claims (except in cases of misconduct or negligence by the bank), but a form of limited-term equity or residual claim, shocks to asset values for assets financed by PSIA are passed on to the PSIA holders and thus do not impact the bank’s own capital. However, Islamic banks are not immune from “runs” in the sense of large volumes of “panic” withdrawals of PSIA funds, which might follow such shocks and could result in financial distress to an Islamic bank in the form of a liquidity crisis. As Dale (1996, 8) points out, a conventional investment firm faced by such problems “will generally be able to wind down its business in an orderly manner, meeting its obligations through prompt asset disposals at close to book value,” since its assets “consist mainly of marketable securities and there will be little difference between [their] value on a going concern basis and in liquidation.” However, Islamic banks tend to invest PSIA funds in assets that are relatively illiquid, such as murabahah, ijarah, and salam. PSIA holders typically have the right to withdraw their funds at short notice subject to forfeiting their share of profit (but not of loss) for the most recent period. Moreover, the investment activities of Islamic banks are conducted under the same corporate umbrella as their banking activities. Also, in the case of unrestricted PSIA, the funds are typically commingled with the bank’s own funds. Hence, losses on asset disposals may impact the bank’s own capital as well as that of the PSIA. (This would not be the case for restricted PSIA funds, unless the bank had invested its own funds in the same asset pool.) PSIA holders who insist on withdrawing their funds must therefore suffer any resultant losses on asset disposals.
Hence, Islamic banks are not immune to systemic risk, but as described above it manifests itself primarily as liquidity risk. The exposure of the bank’s own capital is limited to the effects of forced asset disposals on assets financed on a commingled basis, which should not normally be significant enough to imply a need for the regulation of capital adequacy. However, there may be factors owing to which the juristic nature of PSIA as a form of limited-term equity investment may be overlaid by economic characteristics closer to those of conventional deposits. These are discussed in Subsection 3.4.
In addition, Islamic banks are increasingly using a form of term deposit based on reverse commodity murabahah transactions (CMT) in place of unrestricted PSIA. This is especially true of Islamic investment banks, but is also the case in the “universal” form of Islamic bank with retail operations. As CMT-based deposits have none of the loss-absorbent attributes of PSIA, their use as a source of funds can make Islamic banks more vulnerable to financial distress, because of the “refinancing” risk of being unable to roll over such deposits in stressed credit conditions. (This is why the leverage ratio mentioned above may be relevant to Islamic banks.)
3.2 Market Failure
The rationale for capital adequacy regulation of conventional banks depends partly on the social costs of contagious failure (systemic risk) and partly on the failure of market discipline owing to deposit guarantee schemes (as discussed in Subsection 3.3). However, in the environments in which Islamic banks typically operate, there may be a more general lack of market discipline. This is suggested by recent research carried out by Ariffin (2005) (see also Archer and Karim 2006), and would provide an additional reason for capital adequacy regulation of Islamic banks.
3.3 Displaced Commercial Risk
The above reasoning is based on the juristic nature of PSIA as profit sharing and loss bearing. However, this characterisation requires some qualification, for three reasons:
The above considerations led the Islamic Financial Services Board (IFSB), in its Capital Adequacy Standard, to set out two alternative versions of the CAR for Islamic banks. In the first version, the credit and market risks of assets financed by PSIA are treated as being borne entirely by the PSIA holders. In the second version, a proportion α (alpha) of the risk-weighted assets financed by unrestricted PSIA is included in the denominator of the CAR, which has the effect of requiring the Islamic bank to hold regulatory capital against the credit and market risks of that proportion of those assets. It is up to the national banking supervisor to determine the proportion α for each Islamic bank in its jurisdiction.
In addition, recent research by IFSB (2004) has shown that in some countries PSIA are covered by deposit guarantee schemes, even though this is not Shari’ah-compliant unless the scheme operates on the basis of takaful or is provided by the central bank free of charge. In such an environment, PSIA share (at least to some extent) those characteristics of conventional deposits that give rise to moral hazard and the consequent need for the regulation of capital adequacy.
3.4 Islamic Bank Capital and the Economic Characteristics of PSIA
The above discussion indicates that the economic characteristics of PSIA are complex and may vary between jurisdictions. In no cases are PSIA part of the bank’s capital, but juristically they should be available to absorb all losses resulting from credit or market risk exposures in respect of the assets that they finance, in the absence of misconduct or negligence by the bank. In practice, however, PSIA may be partially assimilated to conventional deposits, with implications for the bank’s own capital (displaced commercial risk), and may even be covered by deposit guarantee schemes. In such cases, as indicated in Subsection 3.3 above, there are implications for the Islamic bank’s capital adequacy that need to be taken into account by including some proportion of the assets financed by PSIA, on a risk-weighted basis, in the denominator of the CAR.
Do PSIA give rise to moral hazard problems similar to those associated with conventional deposits? Certainly, as Al-Deehani, Karim, and Murinde (1999) point out, Islamic banks have incentives to maximise the amount of PSIA that they control. Because PSIA are not liabilities, there is in principle no hard financial constraint on the volume of PSIA funds taken on by a bank; the bank benefits from the mudarib share of profits on managed funds, while incurring only the payroll and associated costs of providing asset management. The constraint is thus a soft constraint of managerial capacity to provide effective asset management, in a context where economies of scale are significant. It is not clear that Islamic banks have any incentive to take on amounts of PSIA funds in excess of what they can effectively manage. However, there could be a problem of incentive misalignment insofar as the unrestricted PSIA holders are likely to be more risk-averse than the bank’s shareholders. This leads to a type of moral hazard problem that is associated with displaced commercial risk. Hence, in environments where displaced commercial risk is a significant factor, the volume of unrestricted PSIA has capital adequacy implications, as discussed earlier.
3.5 Risk Weights for Profit-Sharing Assets
Islamic financing assets that are profit-and-loss sharing (musharakah financing) or are profit sharing and loss bearing (mudarabah financing) are not easily accommodated within the credit risk methodology of the Basel Accords, and therefore called for particular attention from the IFSB in its Capital Adequacy Standard. Where the musharakah or mudarabah assets are commodities or other assets that are held for trading, the risk involved is essentially the market risk of those assets, and there is no particular problem of credit risk.
However, when the mudarabah or musharakah is used as a means of financing and the assets are intended to be held to maturity, the risk is essentially a credit risk—namely, a risk of capital impairment. The provisions of Basel II (Pillar 2) include a category of credit risk referred to as “equity position risk not in the trading book”—that is, in the “banking book.” This category is primarily intended to cater for shares held by banks as long-term investments in companies with which they have a lending relationship, which is a familiar feature of “relationship banking” in some continental European countries. Such shares may or may not be listed on a recognised stock exchange. However, some types of musharakah investment, typically those in a business venture, combine the risk of an equity position (normally unlisted) with a “banking book” intention to hold the investment to maturity. Hence, the IFSB Standard proposes a risk weighting for such assets that is similar to that set out in Basel II for equity position risk exposures in the banking book. Alternatively, some musharakah and mudarabah investments, especially diminishing musharakah, could be seen as a category of “specialised lending” (or, more precisely, specialised financing) for which Basel II provides “supervisory slotting criteria” for arriving at risk weightings. The IFSB Standard allows the use of risk weights based on such criteria as an alternative to those resulting from treatment of such assets as equity positions in the banking book.
The credit risk weightings resulting from the approaches just outlined are high compared to those on other financing assets such as murabahah or ijarah muntahia bittamleek, and, in the case of “equity position risk in the banking book” very high, in the absence of risk mitigation. This emphasises the importance of financing structures in such cases that serve to mitigate credit risk. This has implications for banking supervisors, as mentioned in Section 4.
4. PILLAR 2 OF THE REVISED FRAMEWORK AND RISK MANAGEMENT
Pillar 2 of Basel II is concerned with the supervisory review process, which “is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their assets . . . Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate” (Basel Committee on Banking Supervision, 2004: paragraphs 720 and 722). The following risks are mentioned specifically in the order given below (Basel Committee on Banking Supervision, 2004: paragraphs 733–742), but this list is not intended to be exhaustive.
- Credit risk.
- Operational risk.
- Market risk.
- Interest rate risk in the banking book.
- Liquidity risk.
- Other risks, such as reputational and strategic risk.
From the perspective of Islamic banks, the following call for comment in this section: credit risk; an analogue of interest rate risk in the banking book (namely, displaced commercial risk); and liquidity risk, an increase in which may be one of its consequences.
4.1 Credit Risk
Apart from Islamic banks’ credit risk methodologies and systems in general, the analysis in Subsection 3.5 above indicated a particular need for supervisory attention to the measurement and management of credit risk arising from profit-sharing and loss-bearing assets. Among other matters, supervisors will need to decide which of the two risk measurement methodologies is more appropriate: the market-based approach for equity exposures in the banking book with its high-risk weights; or the supervisory slotting criteria approach for specialised lending with its lower risk weights. In principle, the latter approach should be authorised only when the supervisor is confident that the slotting criteria are appropriate for the credit risk exposures and will be correctly applied.
4.2 Displaced Commercial Risk
In conventional banking, interest rate risk in the banking book results from mismatches between assets and liabilities, as a result of which the rate payable on liabilities exceeds that receivable on assets, thus subjecting the bank to an “interest rate squeeze” that may threaten its viability. For Islamic banks, while there is no interest payable or receivable, there are returns receivable of a mark-up nature (for example, on murabahah assets) or ijarah rentals that are fixed in advance, while the returns expected by PSIA holders (especially for unrestricted PSIA) follow current market expectations. The result is a similar kind of squeeze that leads to displaced commercial risk. The severity of this squeeze and its implications for capital adequacy will depend, among other things, on the economic characteristics of unrestricted PSIA in the country concerned, as discussed in Section 3 above. This matter therefore calls for particular attention from supervisors under Pillar 2. Supervisors need to evaluate the risk management systems of Islamic banks in their jurisdiction, and their exposure to and capability to manage displaced commercial risk.
4.3 Liquidity Risk
When Islamic banks are not considered to have a constructive obligation to maintain the capital of unrestricted PSIA, they may nevertheless face considerable commercial pressure and resultant risk of the withdrawal of PSIA funds—that is, liquidity risk. For systemic reasons mentioned in Section 3 above, liquidity risk tends in any case to be a particular problem for Islamic banks. Supervisors will need to pay particular attention to the issue of whether Islamic banks in their jurisdiction have “adequate systems for measuring, monitoring and controlling liquidity risk . . . [and for evaluating] the adequacy of capital given their liquidity profile and the liquidity of the markets in which they operate” (Basel Committee on Banking Supervision, 2004: paragraph 741). It should also be noted that the BCBS, in Basel III, has given considerable emphasis to the management of liquidity risk, and the IFSB has issued a standard Guiding Principles on Liquidity Risk Management for Institutions Offering Islamic Financial Services (March 2012).
The IFSB also spearheaded the establishment of the International Islamic Liquidity Management Corporation (IILM) in October 2010 whose main objective is to issue high-quality financial instruments that assist Islamic banks and financial institutions in managing their liquidity.
5. CONCLUDING REMARKS
This chapter has reviewed some salient issues in the matter of regulating the capital adequacy of Islamic banks, against the conceptual background of capital adequacy regulation of banks in general. The justification for capital adequacy regulation in the case of conventional banks lies partly in the social costs of contagious collapse (systemic risk), and partly in the lack of market discipline whereby, if fully effective, inadequately capitalised banks would be obliged by market forces to obtain adequate capital or to curtail their activities. A major reason for this lack of market discipline is the existence of deposit guarantee schemes that reduce market incentives to monitor banks.
The analysis above indicated that both the social costs and the market failure rationales apply to Islamic banks, but with some differences as compared to conventional banks. With regard to the social costs rationale, in principle PSIA impose requirements for liquidity rather than capital adequacy. However, a major issue for international guidelines on capital adequacy is the variations between countries in the economic characteristics of unrestricted PSIA. In some countries, they are considered to impose constructive obligations on Islamic banks comparable to those imposed by conventional deposits; in other countries they impose commercial constraints that have a similar effect. In such countries, unrestricted PSIA may account for a large proportion of the funds mobilised by Islamic banks. This leads to the problem of displaced commercial risk in such countries. In other countries, the treatment of unrestricted PSIA is more in accord with their juristic nature in the Shari’ah, while in yet other countries Islamic banks avoid offering unrestricted PSIA at all. Hence, international capital adequacy guidelines must leave scope for national bank supervisors to apply a capital adequacy regime in respect of unrestricted PSIA that fits their economic characteristics in the local environment. In addition, it was noted that there is a trend among Islamic banks to use CMT-based term deposits in place of unrestricted PSIA, which may increase their vulnerability to financial distress.
With regard to the market failure rationale, research indicates that market discipline tends to be weak in the countries in which Islamic banks operate. Also, in some countries, unrestricted PSIA are covered by deposit guarantee schemes. For these reasons, capital adequacy cannot be left to market forces, but requires the intervention of the banking supervisor.
Thus, the rationales for the regulation of capital adequacy for conventional banks are applicable to Islamic banks. Technical rather than conceptual differences exist in the identification, measurement, and mitigation of credit risk and market risk. In the case of asset-side musharakah and mudarabah, the differences are more of a conceptual nature, as such profit-sharing and loss-bearing investments are not normally found in the “banking book” of conventional banks, and if they do exist they receive a very high risk weighting under Basel II. Under appropriate circumstances, and at the supervisor’s discretion, they may, however, be considered under the “specialised lending” provisions of Basel II which involve less onerous risk weightings. Nevertheless, a major conceptual difference (and problem) concerns the economic characteristics of unrestricted PSIA, which vary from their being regarded as virtual deposits (that is, not loss-bearing, and entitled to a fairly predictable return) in some countries, to their being considered in other countries as essentially a form of limited-term equity investment (a position more in line with their juristic nature in accordance with Shari’ah principles). These differences have substantial implications for capital adequacy and for the calculation of the CAR.
NOTE
1. At the time of writing, the IFSB has issued an Exposure Draft of a revised Capital Adequacy Standard in the light of implications of the financial and economic crisis that began in 2007 and of Basel III.
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