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Commodity inventories on Islamic banking institution balance sheets increase the size price and operational risks. Furthermore, due to Islamic banking contracts that consist of deferred delivery of products, such as salam and istisna, considerable additional price risks arise. In order to address the unique risks of Islamic banking, ad- equate capital and reserves are required, which is where Basel II presents itself as a useful set of recommenda- tions and guidelines for Islamic banking.
Also required is control of risks in an appropriate disclo- sure regime. Given information asymmetries and incon- sistencies are widely present in Islamic banking, there is a strong need for better rules and practices for account- ing, governance, disclosure and auditing. Furthermore, there is a need for the development of an infrastructure that facilitates effective liquidity management.
Islamic financial institutions have their work out cut for them in regards to the analysis of the risk characteris- tics of Islamic financial products and understanding how to treat these products under Basel II. Islamic banking bodies are working towards clarifying these issues, the knowledge that the rewards Basel II could potentially bring the Islamic banking industry would be worth it.
Benefits of Basel II for Islamic Banks
The eventual successful implementation of Basel II for Islamic banks would potentially yield rewards such as increased credibility and sustainable worldwide growth. Malaysia, commonly hailed as an Islamic finance centre with its finger on the pulse, has indicated it is aware of the potential for such benefits by developing the Capital Adequacy Framework for Islamic Banks (CAFIB), its own sharia’a-friendly answer to Basel II.
The framework was developed upon the basis of the Capital Adequacy Standard issued back in 2006 by the IFSB. Several Malaysia-based Islamic banks have already adopted it.
According to a 2008 article by Islamic Finance Asia, the country’s central bank, Bank Negara Malaysia is of the opinion, “that most Islamic banks had been observed to experience modest improvements in the capital ad- equacy ratio following the implementation of CAFIB, with increases in capital requirements due to the introduc- tion of a new capital charge for operational risk being mitigated through capital savings enjoyed from lower risk weights for residential mortgages and retail exposures under the new framework.”
Furthermore, “the central bank expects to see capital savings and improved risk management practices in the industry through the supervisory expectations embed- ded within the framework, such as for the recognition of credit risk mitigants for purposes of capital savings. This would also be supported by an enhanced risk manage- ment system infrastructure.”
Certain other countries obviously agree with BNM that the Basel II philosophy can be beneficial to Islamic bank- ing as they are now planning to follow the South-East Asian country’s lead and implement the accord in their own Islamic banks. For instance, last July, Bangladesh’s The Financial Express (FE) reported that the country’s
central bank, the Bangladesh Bank (BB) had released an instruction on risk factors associated with Islamic financing with the aim of bringing the nation’s Islamic banking industry in line with Basel II. A senior official at BB had told FE that, “We’ve issued the instruction under the guideline on risk based capital adequacy for banks to identify credit risks of the Islamic banks.” He reportedly added that both standalone Islamic banks and conven- tional banks with Islamic banking windows would be ex- pected to compute their risk weighted assets and capital reserves requirements for implementation of Basel II.
This would involve the banking institutions measur- ing and applying capital charges against credit, market and operational risk. There are currently seven Islamic standalones and 13 Islamic banking windows in Bang- ladesh.
The official disclosed, “The banks will have to submit their statements on a quarterly basis in prescribed forms to the department of off-site supervision of the central bank from 30th June this year [2009].” Basel II had actu- ally come into effect in Bangladesh on 1st January 2009, but it was only in July that BB made this concerted ef- fort to apply it to Islamic banks. The banks have been required to actually implement the accord since January of this year.
Considering, as we have already explained, such meas- urements are a challenge for Islamic banks to undertake, it certainly proves the regulator’s determination to bring its country’s banking system in line with Basel II. This, in turn, is surely a testament to the positive power, regula- tors believe Basel II has.
This is not just the case in Malaysia and Bangladesh, but all across the Islamic world. It may take a lot of hard work and amendments to reach the point where all Islamic countries have implemented sharia’a-friendly equiva- lents of Basel II, but it would appear that many of them are of the opinion it will all be worth it in the end.
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Additional Reading:
Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P. Tsomocos, Procyclicality and the new Basel Accord - banks’ choice of loan rating system, October 2005, Economic Theory, Volume 26, Number 3
Abdul Hassan, Jumping Hurdles: Adopting Basel II Standards in Islamic Banks, April 2005, The Islamic Foundation
Don Brownlow, Islamic banking and Basel II: Challeng- es Ahead, April 2008, New Horizon
Siddique Islam, Islamic banks to weigh risk factors ac- cording to Basel-II, July 2009, The Financial Express
Islamic Finance Asia contributor, Basel II Enhances Is- lamic Banks, August/September 2008, Islamic Finance Asia
2010 June GlobalIslamic Finance 59
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