29.3.2011

By Mike Kennedy

The profound impact of the global financial crisis prompted G20 leaders to seek agreement on a set of internationally effective rules to improve both the quantity and quality of bank capital as well as to discourage excessive leverage — Basel III.

Given that Islamic banks are liquid and inherently risk averse, the sector avoided many of the speculative products that contributed to the recent economic turmoil. Nevertheless, Islamic banks were not totally immune to the situation: many were left exposed due to over-expansion and excessive risk concentrations, notably in the real estate sector.

Financial institutions must have more and higher quality tier 1 capital (which includes common equity and certain minority interests, as well as deferred tax assets). Tier 1 capital must be fully effective at absorbing losses and tier 2 capital (which includes undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt) must absorb more losses in order to protect capital. Capital, which is additional to minimum capital requirements, is needed to address systemic and procyclicality risks.

The first point to note is that the capital structures of the significant majority of Sharia’a-compliant banks are dominated by tier 1 capital in common equity form, often in excess of 80 per cent of capital resources. In addition, most have capital adequacy ratios noticeably higher than those seen in the conventional banking sector. The reasons for this can be explained by a combination of complexities and Sharia’a prohibitions in raising alternative and lower quality forms of capital, which result in:-
• The lack of Islamic subordinated debt.
• The lack of hybrid and callable capital structures due to the prohibition of Gharar (conditionality and uncertainty).
• The lack of meaningful levels of preference shares, even in Sharia’a jurisdictions that permit this form of capital.

As a consequence of these factors, the capital structures and above average capital ratios of Sharia’a financial institutions put them in a favourable position relative to many of their conventional counterparts. The capital adequacy positions of Sharia’a-compliant banks will also benefit from:-
• The modest role of Trading Book businesses as Sharia’a principles prohibit short selling and impose strict limitations on the use of derivatives. Sharia’a financial institutions will be negligibly impacted by the higher capital charges for such operations.
• The modest and very limited use of derivatives and securitised structures by Sharia’a-compliant banks will result in not being adversely impacted by the additional capital charges that are being applied to address the inherent risks in such products (e.g. wrong way risk).
• The lack of leverage and contingent risks, auger well for Islamic banks in so far as the new leverage ratio is unlikely
to have anything more than a very
modest impact.

Liquidity is, however, one area where both conventional and Sharia’a-compliant banks are likely to be impacted in different ways. Firstly, there remains a dearth of liquid Islamic instruments. Despite progress in the deepening of Islamic liquidity markets, notably the increased Sukuk issuance by the AAA rated Islamic Development Bank, there is a lack of eligible liquidity instruments and central bank facilities. However, these limitations are offset by the relative lack of contingent and leveraged liquidity risk; a generally low reliance on interbank funding; and for many banks strong depositor loyalty.

Stronger and better managed Islamic banks will see Basel III as an opportunity to prosper and strengthen their competitive positions. Many banks may not have this chance.