gif Risk Management


Implication of Basel II in Islamic Finance Institutions


Author: Farhad Reyazat, PhD in Risk Management, Editor in Chief of Global Islamic Finance Magazine, United Kingdom


Abstract: Basel II, the second of the Basel Accords, is a set of recommendations on banking legislation and regulations issued


by the Basel Committee on Banking Supervision. Initially published in June 2004, the objective of the recommendations is to de- velop an international standard for banking regulators worldwide to base their creation of certain regulations upon. These regu- lations relate to the amount of capital banks need to put aside as protection against the various types of risk they are exposed to. Supporters of Basel II believe that an international standard of this nature assists in the safeguarding of the international financial system against the types of problems indicative of major banking crises such as the one experienced in 2007.


Keywords: Basel II, Risk Management, Banking Supervision, Islamic Finance, Islamic Banking


What is Basel II? Basel II, in practice attempts to offer such protection by establishing stern risk and capital management requirements to ensure a bank holds capital reserves appropriately proportionate to the risk the bank in ques- tion exposes itself to through its lending and investment exploits. As one might imagine, ‘appropriately proportionate’ means that, generally speaking, the greater risk to which the bank is exposed, the greater the amount of capital Basel II recommends the bank re- serves back in order to maintain its solvency and overall economic stability. In September 2010 The Bank For International Settle- ments set up a new regulatory framework for banks under the latest Basel III which Is- lamic banks could further consider following on from the existing regulations of Basel II. What has Basel II got to do with Islamic Banking? Basel II applies to Islamic banking institutions just as much as it does to their conventional peers. The degree to which it applies to each bank is dependent on the uptake of the recommendations by the par- ticular country in which the bank in question is based. In many countries Basel II has al- ready been implemented, in other nations, it is still in the process of implementation.


48 Global Islamic Finance February 2011


Islamic banks, often located in the countries where Basel II is not on top of the regulators’ priority list, tend to be comparatively small, which is another factor affecting how much they take Basel II on board.


As a rule, a small bank in country not fully up to speed with Basel II is likely to be less affected by the three pillars of recommenda- tion than a small bank in a country with Ba- sel II fully in place. In an interview with New Horizon, however, respected Islamic finance and banking expert Dr. Natalie Schoon says Basel II generally has the same impact on Is- lamic banks as it does on ‘any of the smaller conventional banks’ around the globe. The real point of differential is not so much be- tween Islamic and conventional, but between small and large. It is widely accepted that, although Basel II theoretically applies in the same way to big and small institutions alike, its impact is, in practice, felt differently in the small banks than in the larger ones. The dif- ferences are not to be found in the concept of the legislation itself, but in the accessibil- ity of associated models and historical data required by a bank to compute how much it needs in terms of capital reserves.


Dr. Schoon explains, “The larger banks are able to progress major development projects, even when the actual capital re- lief was yet unknown.” The development projects to which the academic refers relate to banks’ creation of the customised regu- lations we discuss above, in pillar 1, based on available historical data instead of the ‘standardised approaches’ smaller banks generally have to resort to. Dr. Schoon ex- pands, “Smaller banks, including the Islamic banks, are likely to suffer from a lack of data and a smaller sample size.” These restricts the smaller institutions in their attempts to devise their own regulatory models, whereas larger banks, including both Islamic stan- dalones and Islamic banking windows, are much more easily able to develop bespoke risk models by referring to their own histori- cal experience.


Basel II-Different Approaches by Islamic and Conventional Banks Having said that, when it comes to Basel II, there is more differential between small and big than conventional and Islamic, it must be conceded that there are some differenc- es between Islamic banks’ approach to the pillars and the conventional approach. Due


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