gif Islamic banking regulation
As we discussed in part I, the Internal Ratings-Based Approach used by conventional banking institutions in relation to Basel II would be ideal for Islamic banks, if it could be adapted accordingly. In terms of retail exposures, the IRB approach includes an expanded treatment, with credits categorised thus:
1 Collateralized by residential mortgages .
2. Qualifying revolving retail exposures 3. Other retail exposures
Different products offered by Islamic banks have dif- ferent collateral structures, that could permissibly be classified according to either category 1 or 3 above. The table below demonstrates which Islamic products would be suitable for which category:
Product
Murabaha Salam Istisna
Structure
Residential mortgages
Specialised lending
Specialised lending
Category
1
3 3
Obstacles for Islamic Banks in Implement-
ing Basel II
Islamic banks are gradually handling risk in a much better way as they move towards implementing Ba- sel II. Islamic banks, however, before getting closer to adopting the more advanced features of Basel II, must ensure that a few major obstacles are efficiently dealt with and turned towards their advantage. Using advanced approaches for the calculation and man- agement of risk is currently difficult in some of the Islamic banks operating in the Middle East and Asian countries due to the aforementioned shortage of his- torical data.
Such historical default data, for instance, is required to calculate the probability of default and the poten- tial loss given the estimates of default. This type of data, however, is not easily available in most of Islamic countries. National Commercial Bank, Al-Rajhi Bank and several other banks are working towards creating a national data pooling system for handling credit risk. Bahrain, Malaysia, Qatar and the UAE have developed national databases and banks in the Middle Eastern countries are working on collecting their own historical data. Despite all this, much more needs to be done in order to develop globally competitive databases for the Islamic banking sector.
The reason why Islamic products could not be classi- fied according to the second category is because Is- lamic banks are not permitted by sharia’a law to have revolving credits. Despite the fact that some credit restructuring is allowed, indeed encouraged, in the event of customers facing genuine payment difficul- ties, these cannot be considered as revolving credits.
In terms of classifying risk relevant to the broad, umbrella-like third category, it is a challenging proc- ess but Islamic banks should not be afraid to take the lead to describe risks associated with such credit rela- tionships and to subsequently establish a risk weight foundation.
What of other Islamic finance instruments? Both mudaraba and musharaka could stand to benefit from the special treatment associated with equity participa- tion as handled by the IRB approach. The two different methods for handling equity participation under IRB are:
• Banks’ provision of their own default probabilities for equity participation • Banks’ estimation of the market value decrease of the equity participation.
Either way, Islamic banks would be able to take advan- tage of special treatment. Indeed, the IRB approach to equity participation may well encourage Islamic bank- ing institutions to increasingly utilise mudaraba and musharaka transactions. However, in order to obtain supervisory approval to apply the IRB approach, Islam- ic banks will have to deal with a number of obstacles regarding size and risk management. In fact, in order to implement Basel II in general, there are a variety of obstacles Islamic banking must overcome.
58 GlobalIslamic Finance June 2010
Furthermore, in order to combine data at an interna- tional level, the central banks of the Islamic countries must give their banks the freedom to disclose informa- tion. This would require the cooperation of the central banks across all Islamic countries. Collectives of Is- lamic countries would do well to adopt a standardised policy of disclosing data on their exposures.
The concept of using a proxy database to begin with is currently being worked upon to ensure that Islam- ic banks at least start using more advanced Basel II reporting and compliance. Islamic banking presents unique risks to the financial system. This is due to the profit and loss sharing method of financing so char- acteristic of sharia’a-compliant banking, as well as particular contractual features of Islamic financial products. The profit and loss sharing shifts the risks in the institution to investment depositors to a certain ex- tent. It also makes Islamic banks vulnerable to a range of risks, including those risks that are normally carried by equity investors, because of the following features:
• The profit and loss sharing mechanism is very complex and therefore requires greater auditing of projects to guarantee proper governance and suitable valuation. • It is not permissible for Profit and loss sharing to be made dependent on collateral or guarantees to decrease credit risk. • Product standardisation becomes more complex because of the multiplicity of potential financing methods that can be based upon each product, increased operational risk, and legal uncertainty in interpreting contracts. • Because of the absence of Shariah-compliant in- struments such as treasury bills, it is a challenge to manage asset and liability mismatches and hence, liquidity risks are substantial, to say the least.
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