CAPITAL ADEQUACY NORMS FOR ISLAMIC FINANCIAL INSTITUTIONS
MOHAMAD OBAIDULLAH
Risk is an integral part of the business of financing. Islamic financial institutions, like their conventional counterparts, are subject to many forms of risk, of which credit and market risk are perhaps the most important.
Credit risk involves the risk that a counterparty to a contractual obligation, be it Murabaha, Ijara, Ijara wa Iqtina, or Qard-Al-Hasana, may default on the promised payments. Market risk is the risk that the value of the assets or the cash flows from the assets may change in response to movements in aggregate macroeconomic factors.
For conventional banks, market risk is seen to originate primarily from movements in interest rates and currency rates. Islamic banks and financial institutions are, by definition, less vulnerable to fluctuations in interest rates, as their transactions are supposed to be free from any element of Riba or interest.
Of course, these may not be completely immune from interest-rate risk if Islamic bankers continue to use interest rates directly or indirectly in their investment and financing decisions (perhaps in the case of assets generating a predetermined income, such as Murabaha and Ijara).
Islamic banks, like their conventional counterparts, are also exposed to currency risk. In the case of assets involving equity participation, or Musharaka and Mudaraba, market risk takes the form of general upturns and downturns in the economy affecting the profitability of individual projects.
Bank regulators across the globe have traditionally focused on credit risk and the quality of assets. Th e purpose of such regulations has been to limit the probability that adverse outcomes of exceeding the bank’s capacity to bear losses. Hence, the focus is on capital adequacy, since capital alone provides a buffer or cushion for absorbing potential losses inherent in the bank’s conduct of its normal business. In this paper, we examine the relevance of the existing norms of capital adequacy for Islamic financial institutions.
The Norms
The capital adequacy norms, popularly known as Basle Committee norms, require banks to maintain a minimum ratio of capital to risk-weighted assets at eight per cent. Before these norms were adopted, the principal means of assessing capital adequacy for banks was to simply divide total capital (which included retained earrings, common and preferred stock and certain forms of subordinated debt) by total assets.
The norms assign each asset owned by a bank to one of four risk categories. Each risk category is assigned a “risk weight,” which is used to multiply the amounts in each risk category to determine the amount of capital required by the bank.
Category 1 (zero per cent) includes risk- free assets such as: cash (domestic and foreign) held in the bank or in transit; balances due from central banks; claims on, or that are unconditionally guaranteed by, Central Governments; and net assets in the form of gold.
Category 2 (twenty percent) includes very low-risk assets such as: cash items in the process of collection and claims on, or that are guaranteed by, local governments or government-sponsored agencies etc.
Category 3 (fifty percent) includes riskier assets, such as: revenue bonds or similar claims that are obligations of state or local governments, but for which the government entity is communed to repay the debt only out of revenues from the facilities financed; credit equivalent amounts of interest rate; and foreign exchange rate related contracts, except for those assigned to a lower risk category.
Category 4 (hundred percent) includes assets in the highest risk category, such as: all other claims on private obligors; all fixed assets, including premises, plant and equipment, investments in unconsolidated subsidiaries; joint ventures, or associated companies – if not deducted from capital – and the like.
The norms also explicitly take into account off-balance sheet exposures of a bank in the assessment of capital adequacy. Off-balance sheet items represent contingent assets (or liabilities) that the accounting profession does not require to be entered on the face of a bank’s financial statement because of the uncertain nature of the contingencies that determine whether these items become due and payable (i.e., move onto the balance sheet).
Most accountants do require that, as contingent items, they be disclosed in footnotes to the financial statements. Some typical off-balance sheet transactions are letters of credit, sale and repurchase agreements, forward agreements, futures, swaps etc. The face amount of the off-balance sheet item is taken into the risk-based capital ratio by multiplying it by a ‘credit conversion factor’. The resultant ‘credit equivalent amount’ is assigned to the appropriate risk category (according to the identity of the obligor or guarantor).
Capital is divided into “Tier 1,” or “core” capital (consisting of retained earnings, common stock, and non-cumulative perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, minus “goodwill”) and “Tier 2” capital (various forms of ‘supplementary’ capital, such as hybrid instruments, equity contract notes, intermediate-term preferred stock, subordinated debt, allowances for loans and leases). The total of tier 2 capital cannot exceed hundred per cent of tier I capital for the purpose of assessment of capital adequacy.
Assets and Capital of Islamic Financial Institutions
The business of Islamic banking and the assets of Islamic financial institutions are distinct from those of their conventional counterparts. As per the definitions of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), these are generally in the form of cash and cash equivalents; receivables relating to Murabaha, Salam, and Istisna; investments in securities; Mudaraba investments; Musharaka (participation and joint ventures) investments; investments in other entities; inventories (including goods purchased for Murabaha customers prior to consummation of a Murabaha agreement); investments in real estate; assets acquired for Ijara; and fixed and other assets.
The Basle Committee norms would require that cash and cash equivalents be placed in the zero-risk category. Receivables would be assigned to one of the latter three categories, depending upon the identity of the obligor or the guarantor. All investments in Mudaraba, Musharaka, real estate and fixed assets would be in the hundred per cent risk category.
Capital for an Islamic financial institution comprises owner’s equity, unrestricted investment accounts and their equivalents. Owner’s equity, as per the AAOIFI definition, refers to the “amount remaining from the Islamic bank’s assets after deducting the bank’s liabilities, equity of unrestricted investment account holders and their equivalent and prohibited earnings, if any.” Owner’s equity would obviously form part of tier 1 capital. There is, however, considerable difference of opinion regarding inclusion of unrestricted investment accounts in capital.
Unrestricted investment accounts are unique to Islamic financial institutions. According to the AAOIFI definition: “unrestricted investment accounts refer to funds received by the Islamic bank from individuals and others on the basis that the Islamic bank will have the right to use and invest those funds without restrictions, including the Islamic bank’s right to commingle those invested funds with its own investments, in exchange for proportionate participation in profits and losses after the Islamic bank receives its share of profit as a Mudarib”.
Hence, unrestricted investment accounts are considered to be one of the elements of the financial position of the Islamic bank (as distinct from restricted investment accounts which are not considered an element of the Islamic bank’s financial position, because the Islamic bank does not have unconditional right to use or dispose of these funds. These are valued at the amount remaining from the funds originally received by the Islamic bank from the account holders, plus (or minus) their share in the profits (or losses), and decreased by withdrawals or transfers to other types of accounts.
Holders of unrestricted investment accounts and their equivalent receive a share of profits according to what is agreed in their contract with the Islamic bank, and bear their share of loss based on the relative contribution of their invested funds.
The equity of unrestricted investment account holders and their equivalent is not considered a liability, since the Islamic bank is not obligated in the case of loss to return the original amount of funds received from the account holders, unless the loss is due to negligence or breach of contract. Thus, these differ from conventional deposits, which involve an obligation on the part of the bank to service them at a fixed or floating rate, as the case may be, irrespective of whether the bank generates profits or losses on its assets.
Since an Islamic bank can pass on its losses to the holders of such accounts, these should form part of the capital for the purpose of assessment of capital adequacy (for possible absorption of losses on assets and investments).
Should unrestricted investment accounts be ti-eated as tier I capital at par with owner’s equity? The answer seems to be negative, because of some differences between the two.
The equity of unrestricted investment account holders and their equivalent, is different from ownership equity in the sense that the holders of these accounts and their equivalent do not enjoy the same ownership rights, for example, voting rights and entitlement to profits realised from investing funds provided by current and other non-investment accounts.
Current accounts and other non-investment accounts are guaranteed by owners’ equity and not by the equity of unrestricted investment account holders or their equivalent. Further, while owners’ equity is perpetual capital, the latter normally have a finite maturity period and also may contain a put option or a right for the holders to exit even before the time of redemption.
Should unrestricted investment accounts be treated as tier 2 capital? The answer is obviously, yes. It may be noted that Basle Committee norms include irredeemable and intermediate-term preferred stock and subordinated debt in tier 2 capital. Unrestricted investment accounts certainly involve a much greater degree of flexibility for the bank in terms of servicing as compared to the above two.
Critics of the above contention, however, point out that the so-called flexibility may be a myth in times of declining profits and cash flows, since the banks may be forced to maintain stable returns in the face of intense competitive pressures to retain their deposits. The fear of loss of market may lead to a distribution policy unrelated to the profit generating ability of the bank. The following suggestions may be made in order to counter this.
Investment accounts of Islamic financial institutions operate in a manner similar to open-end or closed-end mutual funds, depending upon whether or not the account holders have a right to withdraw. Such funds are, in general, clearly categorised into growth-oriented and income-oriented ones.
In the case of a growth-oriented fund, the investor looks forward to capital appreciation and not recurring income, and the investments of the fund are predominantly in equity. In an income-fund, however, the investor expects a stable stream of periodic income and hence, funds are predominantly invested in fixed-income securities.
As far as the funds mobilised under investment accounts are concerned, a rational Islamic investor should not expect a stable income, unless, of course, the asset composition of the bank is predominantly in Murabaha or Ijara-wa-Iqtina. If the investments are concentrated in long-term avenues, then the investor should also have a long-time horizon and should look forward to returns in the form of capital appreciation.
There is merit in the argument that banks in such cases need not be under pressure to stabilise the periodic disbursements to account holders. The banks must, however, in such cases, declare the Net Asset Value (NAV) of these funds at frequent intervals. This would enable the investors to continuously monitor the performance of the fund using the NAV.
The level of distributed income would automatically lose its significance as a performance measure. The NAV measure would also ensure a fair deal to investors who would like to opt out. There is a need, therefore, of clarity, and adequate disclosure about the investment objective and a possible bifurcation of the investment accounts, on lines similar to growth or income-oriented funds. While the latter may not be treated as part of tier 2 capital, there is no reason why the former should not be.
<fig 2 pic>
Some Empirical Observations
What do the capital adequacy ratios for Islamic financial institutions look like? We attempted to compute these ratios for a sample of ten Islamic banks, using data from their annual reports. These are presented in table 1.
In view of the fact that there is a gross discrepancy between the accounting practices of Islamic banks, these ratios are crude and at best, indicative. Further, due to lack of information on the identity of obligors or guarantors in the case of receivables, we placed all receivables and investments, except risk-free assets, such as cash, in the hundred per cent categories. Hence, the ratios are grossly understated. Even then, they are generally found to be far higher than the minimum required ratio – four per cent with tier I capital and eight percent with total capital as the numerator.
The Question of Derivatives
Unlike their conventional counterparts. Islamic banks do not deal in derivative contracts such as, options, futures, swaps and their other exotic variants in a significant way. Sharia Boards of many Islamic banks consider these instruments as un-Islamic, either because they are unduly complex, or because they are highly susceptible to speculation. While a discussion of the Sharia-related issues is beyond the scope of this paper, the fact remains that the extent of use of such instruments by Islamic financial institutions is insignificant.
Derivatives are assets whose value and payoffs are determined by the value of the underlying asset or index. These instruments are considered useful as hedging devices, as they make possible the transfer of risk, such as that arising from volatility of interest rates, stock prices, commodity prices, and currency exchange rates, from one party to the other.
The dark side of these instruments is, however, that they can be used for speculation with possibilities of unlimited gains and losses and hence, threaten the very existence of the organisation if expectations go wrong. While there is a dearth of data on whether bankers across the globe use derivatives for hedging or speculation, regulators are alarmed over the explosive growth in such transactions by banks. Islamic banks are fortunately immune to the risk-enhancing possibilities of such exposures. At the same time, a search is on to identify hedging techniques which are Islamically permissible.
To sum up, Islamic banks and financial institutions, like their conventional counterparts, are exposed to various forms of risk. However, unlike conventional banks, they can pass on risk to their depositors, namely, the holders of unrestricted investment accounts. Like capital, unrestricted investment accounts can absorb potential losses on the assets of Islamic banks. This is a unique feature of Islamic banking and finance.
Hence, there is a strong case for inclusion of unrestricted investment accounts in capital adequacy measures. These measures, computed for Islamic financial institutions, are, in general, found to be extremely high, much higher than the minimum required as per Basle Committee norms. Hence, Islamic financial institutions are observed to be quite robust. The robustness is further improved by their abhorrence of speculative transactions in derivatives.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.