Managing Islamic Banks Capital

BWBS2083
Introduction

 Definition
 Bank capital can simply be defined as the differences between bank assets and deposits
(assuming deposits are the only bank liabilities).
 Using an accounting definition, bank capital refers to paid ordinary shares, surplus and
undistributed profits.
 Asset minus liabilities and minus certain types of debts and reserves stipulated by the
regulatory body.
Islamic Bank Capital

 1. Equity
 Comprised of common stock, surplus and undivided profits
 IBs raise initial capital or paid-up capital among the initial shareholders via ordinary
shares

 2. Reserves
 Set aside to meet anticipated IB operating losses from financing, leases and
investments

 3. Hybrid instruments
 Combine certain characteristics of equity and certain characteristics of debt
Types of Bank Capital

Bank’s
Capital

Tier 1 Capital Tier 2 Capital

(Basic/Core (Additional/secondary
capital) capital)

Ordinary Unappropriated Debentur Convertible

Shares profits e securities

Preference Contingency
Shares reserves

Capital Loan loss

Reserves reserves
 Ordinary share :
 Any shares that are not preferred shares and do not have any predetermined
dividend amounts. An ordinary share represents equity ownership in a
company and entitles the owner to a vote in matters put before shareholders
in proportion to their percentage ownership in the company.
 Preference share:
 Company stock with dividends that are paid to shareholders before common
stock dividends are paid out. In the event of a company bankruptcy,
preferred stock shareholders have a right to be paid company assets first
 Capital reserves:
 A type of account on a company's balance sheet that is reserved for long-
term capital investment projects or any other large and anticipated
expense(s) that will be incurred in the future
 Unappropriated profits:
 Any portion of company earnings that are not classified as
appropriated retained earnings. Unappropriated retained earnings
cannot be allocated for a specific purpose, such as factory construction
or marketing. They are generally passed on to shareholders in the form
of dividends.

 Loan Loss Reserve:

 An expense set aside as an allowance for bad loans (customer defaults,
or terms of a loan have to be renegotiated, etc).
The Importance of Bank Capital

 Capital adequacy requirements

 provide a buffer against bank losses
 protects creditors in the event of bank fails
 creates disincentive for excessive risk taking
Risk
 Risk can be classified according to activities: market risk, economic
environment changes, management and operations risks (Graham and
Horner, 1988; Santoso, 2004).

 The following defines risk arising from a bank’s operations or activities;

credit risk, liquidity risk, market risk, diversification risk, interest rate
risk and operational risk.

 Risk in banking can first be subdivided into ‘on-balance sheet’ and ‘off-
balance sheet’ risk. These on- and off-balance sheet items expose banks
to several risks (Greenbaum and Thakor, 1995).
Types of Risk

 First, there is the credit risk. This is the risk that its debtors will not pay their interest and
loan repayments on time. Thus, every bank is exposed to unexpected losses incurred as a
result of a customer’s default.
 Liquidity risk, on the other hand, relates to the bank’s liabilities. It is the risk associated
with sudden withdrawal of funds by its creditors (depositors) at any time. It is the
probability of a bank being unable to meet its short-term obligations such as the current and
savings accounts.
 Financial institutions are also exposed to interest rate risk (for Islamic banking, rate of
return risk), which refers to the exposure of the bank’s financial condition to the adverse
movements in the interest rates.

 Banks are also exposed to the risk of changes in market prices or market risk. This refers to
the risk of losses in on- and off-balance sheet positions arising as a result of unexpected
changes in market prices via market interest rates, exchange rates, equity and commodity
 Finally, there is the operational risk.
In recent years, there has been an accelerated increase in the regulators and banking
industry’s awareness of operational risk.

 The on-going transformation in the business of banking, risk management practices,

supervisory approaches and financial markets contribute to operational risk’s importance to
banks and regulators (Basel Committee, 2003).

 Operational risk is defined as losses resulting from events that include: (a) internal fraud,
(b) external fraud, (c) employment practices and workplace safety, (d) clients, products and
business practices, (e) damage to physical assets, (f) business, disruption and system
failures, and (g) execution, delivery and process management (Basel Committee, 2003).
Capital adequacy measurement methods

Capital adequacy measurement methods

Quantitative Qualitative

Capital ratios Capital adequacy ratios

Capital to
Capital to Capital to
risk Capital to
total deposits total assets
weighted loans ratio
ratio ratio
assets ratio
Measuring the size of Bank Capital - CAR

Definition
 CA is any level of capital that allows a bank to absorb or accommodate
any losses and at the same time equips the bank with sufficient funds to
sustain and carry on its business as a continuing entity.

 WHY BANK MUST HAVE ENOUGH CAPITAL?

 Balance the interests of depositors, creditors, shareholders and borrowers.
 Protect depositors and creditors from losses.
 Maintain general public’s confidence in the stability of the bank.
 Provide funds for lending purposes.
How much capital an IB should have?

  Initially,


 Due to increasing role of capital and more exposure to risk, capital ratio is
modified:
RISK-WEIGHTED ASSETS

Risk-weighted asset (also referred to as RWA) is a bank's assets or off-balance-sheet

exposures, weighted according to risk. This sort of asset calculation is used in determining
the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution.

In the Basel I accord published by the Basel Committee on Banking Supervision (BCBS),
the Committee explains why using a risk-weight approach is the preferred methodology
which banks should adopt for capital calculation:
 it provides an easier approach to compare banks across different geographies
 off-balance-sheet exposures can be easily included in capital adequacy calculations
 banks are not deferred from carrying low risk liquid assets in their books
'Risk-Weighted Assets'

 Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and
other institutions to reduce the risk of insolvency.

 The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is
secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is
secured with collateral.
Weighing Risk
 Bank assets are more than the cash in the vault. Loans and investments are assets, but they're not as safe as
cash. Every loan a bank makes comes with a risk the borrower might default. Most investments come with
the risk of losing the investment. Different bank assets have different degrees of risk: investing in T-bills is
very low risk, while high yield junk bonds are much less secure. Loaning money to Microsoft is safer than
loaning to a struggling start-up. A loan secured by real estate offers a lower risk than one with no collateral.
 To calculate risk, the bank segregates the different assets into different groups, based on the level of risk and
the potential for loss. The bank then applies the same risk-weighting formula to all the assets in each group.
How Much Risk

 The rules for risk weighting are set by global banking overseers based in Basel,
Switzerland. As of 2018, the risk-weighting rules are set by a worldwide financial
agreement known as Basel III, though some risk-weighting is still covered by the earlier
Basel II. Basel III is significantly tougher.
 Under the Basel rules, banks must hold capital equal to 7 percent of their risk-weighted
assets. If the risk-weighted assets equal $500 million, the bank needs $35 million in
capital. That amount should cover the bank's exposure if any of the potential losses
become reality.
 Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable CAR protects
bank depositors and the financial system as a whole. Expressed as a formula, the CAR
equals the sum of the bank's tier one capital plus tier two capital, divided by its risk-
weighted assets.
CAPITAL ADEQUACY RATIO

 Minimum capital adequacy ratio (CAR) = Free capital / Total assets

 “Free” capital consists of shareholders’ funds net of investment in long term assets.
The minimum ratios stipulated by BNM are 4% for local banks and 6% for foreign
banks.

 Minimum CAR does not take into account of the risk structure of assets. Thus Risk
Weighted Average Ratio (RWCR) was introduced.
 RWCR = Capital / Total risk weighted assets

 Total risk weighted assets = Balance sheet items + (Off-balance sheet items X
Credit conversion factor) X Risk weighting
Five categories of bank’s asset by RWCR

 0% category – cash and Malaysian government securities.

 10% category – Investment in money market instruments and Cagamas bonds.
 20% category – Loans guaranteed by financial institutions.
 50% category – Housing Loans.
 100% category – Other loan and advances.
Capital Adequacy Ratio

CAPITAL RISK-WEIGHTED TOTAL ASSET

ASSETS
Tier 1 4% 3%
Tier 1 + Tier 2 (Total Capital) 8% No requirements

 Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable CAR protects
bank depositors and the financial system as a whole. Expressed as a formula, the CAR
equals the sum of the bank's tier one capital plus tier two capital, divided by its risk-
weighted assets.
 BASEL III ACCORD. The implementation date of the final version of the third accord has been moved to the end of
March 2019

 Calculate a bank's tier 1 capital ratio by dividing its tier 1 capital by its total risk-weighted assets. Tier 1 capital includes a
bank's shareholders' equity and retained earnings. Risk-weighted assets are a bank's assets weighted according to their risk
exposure.

BREAKING DOWN 'Tier 1 Capital'

 From a regulator’s point of view, Tier 1 capital is the core measure of the financial strength of a bank because it is composed of
core capital.
 Core Capital
 Core capital is composed primarily of disclosed reserves (also known as retained earnings) and common stock. It can also
include noncumulative, nonredeemable preferred stock.

 The Basel III (aka the third Basel Accord) was developed in order to respond to deficiencies in financial regulation that were
exposed by the world financial crisis in 2007 and 2008.

 Under the issued version of the Basel III, the minimum capital ratio is 6%. This ratio is calculated by dividing Tier 1 capital by its
total risk-based assets.
BASEL ACCORD

 Tier 2 Capital
 Tier 2 capital is a measure of a bank's financial strength with regard to the second most
reliable forms of financial capital, from a regulator's point of view. It consists of accumulated
after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term
holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital
instruments, and subordinated debt.

 In 2017, under Basel III, the minimum total capital ratio was 12.5%, which indicates the
minimum Tier 2 capital ratio is 2%, as opposed to 10.5% for the Tier 1 capital ratio.
Capital Adequacy Ratio (CAR)

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the
adequacy of their capital keeping in view their risk exposures.
Banking regulators require a minimum capital adequacy ratio so as to provide the banks with
a cushion to absorb losses before they become insolvent. This improves stability in financial
markets and protects deposit-holders.
Basel Committee on Banking Supervision of the Bank of International Settlements develops
rules related to capital adequacy which member countries are expected to follow.
The committee's latest pronouncement on capital adequacy is Basel III, issued December
2010, revised June 2011.

Tier 1 Capital + Tier 2 Capital

Capital Adequacy Ratio =
Risk-weighted Exposures
CAR

Formula

Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1

Total Capital = Tier 1 Capital + Tier 2 Capital

Risk-weighted exposures include weighted sum of the banks credit exposures (including
those appearing on the bank's balance sheet and those not appearing).

The weights are determined in accordance with

the Basel Committee guidance for assets of each credit rating slab.
Steps for calculating CAR

1. Calculation of Capital
2. Calculation of Risk-Weighted Assets or Credit Exposures
1. On balance Sheet Exposures:
Amount x Risk weights
2. Off-Balance-Sheet Exposure
a) Calculation of Credit Equivalent (convert to on-balance-sheet equivalent)
b) Risk weight is applied to the credit equivalent according to the nature of the obligor
3. Total
3. Calculation of Capital Adequacy Ratios
1. Tier 1
2. Total Capital
 BALANCE SHEET ITEMS
ASSETS CAPITAL
RM RM
(MILLIO (MILLIO
N)
N)

BNM Statutory Reserve 30 Paid-up ordinary shares 20

Malaysian government securities (MSG) and treasury 50 Share premium 4

bills

Placement with discount houses 40 Retained earnings 16

Amounts owed by banking institutions 60 Subordinated term loan 10

Housing loans secured by first charge on residential 100 Revaluation reserve 4

property

Loans and advances provided to commercial 480 General provision for bad debts and doubtful 6
customers debts

TOTAL RISK-WEIGHTED ASSETS

Example
Bank Y has the following assets and financial details
Balance Sheet Items RM Risk RWA RWA RWA
(M’) Weightage RM(M’) RM(M’) RM(M’)
B/S OFF B/S
BNM Statutory Reserve 30 0% 0 0
Malaysian government securities (MSG) and treasury bills 50 0% 0 0
Placement with discount houses 40 10% 4 4
Amounts owed by banking institutions 60 20% 12 12
Housing loans secured by first charge on residential property 100 50% 50 50

Loans and advances provided to commercial customers 480 100% 480 480
Housing loans sold to Cagamas (Off balance sheet item) 60 50% 30 30
Performance bonds for commercial customers (Off balance sheet item) 10 100% 10 10

Letters of credit for commercial customers 14 100% 14 14

TOTAL RISK-WEIGHTED ASSETS 546 54 600
OFF-BALANCE SHEET ITEMS

Amount Credit Credit Risk RWA

Off-Balance Sheet Items (RM Conversion Equivalent weightage
Factor Amount
Million)
Housing loans sold to Cagamas 60 100% 60 50% 30
with recourse
Performance bonds for commercial 20 50% 10 100% 10
customers
Letters of credit for commercial 70 20% 14 100% 14
customers
 Capital RM Million
Paid-up ordinary shares 20
Share premium 4
Retained earnings 16
Subordinated term loan 10
Revaluation reserve 4
General provision for bad debts and doubtful debts 6
Calculation of Risk Weighted Assets or Credit Exposures

Exposure Type Amt + Credit = Total X Risk = Risk

Equiv. Weighting Weighted
asset
Statutory reserve 30 + 0 = 30 X 0% = -
MGS and treasury bills 50 + 0 = 50 X 0% = -
Placements with discount house 40 + 0 = 40 X 10% = 4

Amounts owed by banking 60 + 0 = 60 X 20% = 12

institutions

Housing Loans 100 + 60 = 160 X 50% = 80

Claims against non-bank private 480 + 24 = 504 X 100% = 504
sector

Total 600
RWCR = Capital fund / Total weighted assets

= RM60 million / RM600 million

= 10%

A 10% RWCR which is higher than the minimum ratio of 8% imposed by

BNM shows that Bank Y has fulfilled the Capital Adequacy requirement.
Basel II & BNM Guidelines on Bank Capital

 The reason was to create a level playing field for “internationally active banks”

 Banks from different countries competing for the same loans would have to set aside
roughly the same amount of capital on the loans.

 The purpose was to prevent international banks from building business volume without
adequate capital backing
 The focus was on credit risk
 Set minimum capital standards for banks
 Became effective at the end of 1992
BASEL-II

Basel-II consists of three pillars:

 Minimum capital requirements for credit risk, market risk and operational risk—
expanding the 1988 Accord (Pillar I)
 Supervisory review of an institution’s capital adequacy and internal assessment
process (Pillar II)
 Effective use of market discipline as a lever to strengthen disclosure and encourage
safe and sound banking practices (Pillar III)
IMPLEMENTATION OF THE BASEL II ACCORD

 Implementation of the Basel II Framework continues to move forward around the globe.
A significant number of countries and banks already implemented the standardized and
foundation approaches as of the beginning of 2007.

 In many other jurisdictions, the necessary infrastructure (legislation, regulation,

supervisory guidance, etc) to implement the Framework is either in place or in process,
which will allow a growing number of countries to proceed with implementation of Basel
II’s advanced approaches in 2008 and 2009.

 This progress is taking place in both Basel Committee member and non-member
countries.
BASEL-II (1) Minimum Capital Requirement (MCR)

PILLAR I: Minimum Capital Requirement

1) Capital Measurement: New Methods

2) Market Risk: In Line with 1993 & 1996
3) Operational Risk: Working on new methods

Pillar I is trying to achieve

 If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that
generate high internal capital charges, their formal risk-based capital charges should also be high

 Likewise, lower risk loans should carry lower risk-based capital charges
BASEL-II

Credit Risk Measurement

1) Standard Method: Using external rating for determining risk weights
2) Internal Ratings Method (IRB)
a) Basic IRB: Bank computes only the probability of default
b) Advanced IRB: Bank computes all risk components
(except effective maturity)

Operational Risk Measurement

 Basic Indicator Approach
 Standard Approach
 Internal Measurement Approach
BASEL-II

Pillar I also adds a new capital component for operational risk

 Operational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct,
errors in models or natural or man-made catastrophes, among others.
PILLAR 2: Supervisory Review Process
 Banks are advised to develop an internal capital assessment process and set targets for capital to
commensurate with the bank’s risk profile.

 Supervisory authority is responsible for evaluating how well banks are assessing their capital
adequacy.

PILLAR 3: Market Discipline

Aims to reinforce market discipline through enhanced disclosure by banks. It is an indirect approach, that
assumes sufficient competition within the banking sector.
IMPLICATIONS OF BASEL-II

The practices in Basel II represent several important departures from the traditional
calculation of bank capital.
 The very largest banks will operate under a system that is different than that used
by other banks
 The implications of this for long-term competition between these banks is
uncertain, but merits further attention.

PILLAR 3: Market Discipline

Aims to reinforce market discipline through enhanced disclosure by banks. It is an indirect
approach, that assumes sufficient competition within the banking sector.
PRO-CYCLICALITY OF THE CAPITAL ADEQUACY REQUIREMENT

 “In a downturn, when a bank’s capital base is likely being

eroded by loan losses, its existing (non-defaulted) borrowers
will be downgraded by the relevant credit-risk models, forcing
the bank to hold more capital against its current loan portfolio.
To the extent that it is difficult or costly for the bank to raise
fresh external capital in bad times, it will be forced to cut back
on its lending activity, thereby contributing to a worsening of
the initial downturn.”
Kashyap & Stein (2004, p. 18)