International Journal of Excellence in Islamic Banking and Finance Page 1
International Journal of Excellence
in Islamic Banking and Finance
The Implementation of Basel II by Islamic Banks: The Case of Bank Islam
Malaysia Berhad
Abdou DIAW
The International Centre for Education in Islamic Finance (INCEIF)
Kuala Lumpur, Malaysia
Omaima El Tahir Babikir Mohamed
The International Centre for Education in Islamic Finance (INCEIF)
Kuala Lumpur, Malaysia
ISSN 2220-8291
VOLUME 1 – Issue 2
September 2011
© Hamdan Bin Mohammed e-University, 2011
International Journal of Excellence in Islamic Banking and Finance Page 2
Abstract
Purpose
This paper is a case study of the
implementation of Basel II Accords, under the
reformulation of IFSB, by Islamic banks with
special reference to Bank Islamic Malaysia
Berhad (BIMB).
Method
We have analysed the content of BIMB annual
reports and interviewed a senior executive to
determine the extent of the implementation
and to identify the issues.
Findings
We have found that BIMB is well capitalised
and is using the standardised and basic
indicator approaches for the calculation of risk
weighted assets. Among all the 3 types of risk
that require capital for their management in
the context of Basel II, credit risk is the most
important at BIMB, as its proportion in the total
risk weighted assets is more than 86%. This can
be explained by the overreliance of BIMB on
debt instruments in its financing activities,
corresponding to more 99%, while equity based
financing represents 0.1%. Basel II seemed to
favor the big banks which are able to set up the
required infrastructure for the implementation
of advance approaches for risk measurement,
which could allow them to qualify for less
capital charge.
Originality
The paper is one of the rare attempts to
investigate the implementation of Basel
Accords by Islamic banks in the Malaysian
context where the Central bank has
reformulated these Accords by taking into
consideration the relevant IFBS Standards.
Keywords: Basel II, IFSB, BNM, Bank Islam, Risk
management.
Introduction
In the aftermath of the recent financial crisis,
many have pointed out the deregulation in
most of the financial markets as a determinant
cause of the crisis. Though deregulation was
thought to be a sine qua non condition for a
well functioning financial markets, one of the
major players in these financial markets, the
banking sector, has been progressively
regulated through the standards issued by the
Basel Committee on Banking Supervision
(BCBS), starting from 1988. The efforts of the
BCBS have culminated with the issuance of the
Basel II Accords, which constitute a general
framework for risk management in the banking
industry. However, the global financial crisis has
revealed many shortcomings of this framework.
This has led to the development of new
accords, termed as ‘Basel III’i, that aim to
further strengthen the resilience of the banking
sector.
On the other hand, Basel II also comports
several inadequacies with respect to the
specificities of Islamic Financial Institutions
which are supposed to conduct their operations
according to Sharī'ah principles. To address
these specificities, the Islamic Financial Services
Board (IFSB) was established as a standards-
setting body.
In Malaysia, a leading country in the area of
Islamic finance, the implementation of the
Basel II framework has started since 2008; the
central bank of Malaysia Bank Negara Malaysia
(BNM) has issued several guidelines for the
purpose of customizing the standards issued by
the international organizations and smoothen
their implementation.
In this paper we investigated the
implementation of Basel II Accords by Islamic
banks in Malaysia with special reference to
International Journal of Excellence in Islamic Banking and Finance Page 3
Bank Islam Malaysia Berhad (BIMB). For this
purpose, we have studied the annual reports
2008 and 2009 of the bank and interviewed a
senior executive in the risk department of the
Bank, in order to identify the issues faced by
Islamic banks in the process of implementing
Basel II.
The remaining of the paper is as follows: in the
next section we will present an overview of
Basel II. Section 3 will be consecrated to the
presentation of IFSB and its standards which are
related to Basel II. In section 4 we discuss the
guidelines issued by BNM in relation with the
implementation of Basel II. In section 5 we carry
out the investigation of the implementation of
Basel II by BIMB and the related issues. The
conclusion will constitute the final section.
BASEL II AS A GENERAL FRAMEWORK FOR RISK
MANAGEMENT
Risk management, as a means for value
preservation, has become an area of central
interest for academicians, managers and
regulators. For the regulators this interest is
manifested through the establishment of The
BCBS in 1974 by the Governors of G-10
countries.
The safeguard of the banking organizations is of
crucial importance due to their role as financial
intermediaries in the contemporary economies.
Thus, the failure of any bank, even a small one,
may trigger a contagion effect which results in a
disruption of the payment system and a
negative impact on the economy as a whole.
Basel I: A Landmark in Banking Regulation
With the numerous bank failures in the 1980s,
BCBS concluded Basel Accord (Basel I) in 1988
which constituted a landmark financial
agreement. The main purpose of the 1988 Basel
accord was to provide general terms and
conditions for commercial banks by means of a
minimum standard of capital requirements to
be applied in all member countries. The accord
contained minimal capital standards for the
support of credit risks on balance and off-
balance positions, as well as a definition of the
countable equity capital (Gallati, 2003).
However, despite the significant contribution of
Basel I, there were many drawbacks in the
Accord which called for important
amendments. Firstly, the Basel I was meant for
internationally active banks of G10 and other
OECD countries. But it was embraced by other
countries which do not belong to these two
entities; hence it became desirable to make
adjustments to render it suitable to these
developing countries. Second, Basel I Accord
had encouraged capital arbitrage opportunities,
particularly by encouraging off-balance sheet
and trading activities. For instance, through
securitization good quality assets have been
taken away from the balance sheets of banks
and sold for raising additional funds without
removing the corresponding liabilities from the
balance sheets (Khan and Ahmad, 2001; p.86).
Thirdly, the Accord also completely ignored the
problem of setting aside capital adequacy for
the tradable securities in the trading book.
For all these reasons, among others, the new
Basel II accord was necessary to cater for the
issues raised by the shortcomings of Basel I.
Basel II: Objectives, Rational and Structure
As pointed out by the Basel Committee
fundamental objective of the comprehensive
revised version of the International
Convergence of Capital Measurement and
Capital Standard (Basel II Accords) has been to
develop a framework that would further
strengthen the soundness and stability of the
international banking system while maintaining
sufficient consistency that capital adequacy
Page 4 Volume 1 Issue 2 – September 2011
regulation will not be a significant source of
competitive inequality among internationally
active banks (BIS, 2006; p. 2).
Basel II contains some major innovations,
designed to introduce greater risk sensitivity
into the accord. One was to supplement the
current quantitative standard with two
additional pillars dealing with supervisory
review and market discipline. The second
innovation was the integration of market risk as
well as operational risk, beside credit risk, in the
calculation of the minimum capital
requirement. Another innovation of the new
accord was that banks with advanced risk
management capabilities could use their own
internal systems for evaluating risk, instead of
using the basic or standardised approaches for
measuring risk, upon the approval of the
supervisory authority (Gallati, 2003; p. 346).
Basel II is constituted of three pillars which are
mutually reinforcing to ensure the safety and
soundness of the financial system.
Pillar 1: Minimum Capital
Requirement
Pillar 2: Supervisory Review
Process Pillar 3: Market Discipline
Calculation of capital charge is
connected to credit risk, market
risk, and operational risk,
signifying higher charge for higher
risk in each category.
Supervisors can review and
revise the charge if they feel
that the calculated charge does
not adequately reflect and cover
the risk.
The details of risk management
are required to be made public by
the bank, improving the sharing
of information within the
industry.
Table 1: adapted from Akkizidis and Kumar (2007).
Pillar I: Minimum Capital Requirementii
The Pillar I establishes minimum capital
requirements. The new framework maintains
the minimum requirement of 8 % of capital to
risk-weighted assets. In this framework, capital
represents resources which can be used to
meet current losses while leaving banking
institutions with the ability to continue
operating as a going concern. While equity and
disclosed reserves are the main components of
capital for banking institutions, there are other
legitimate constituents of capital which may be
included for the purposes of the capital base
computation. The capital base, which is used to
compute the Capital Adequacy Ratio (CAR) is
defined as the sum of Eligible Tier 1 Capital and
Eligible Tier 2 Capital less any other deductions
from total capitaliii.
The capital adequacy is measured as follows:
%8)(
riskslOperationarisksmarketCreditAssetsweightedRisk
CapitalTotal
Basel II provides a flexible framework for the
calculation of the weight for each category of
risk. It also provides guidelines for mitigating
the risks faced by the banks in the course of
their business.
Pillar 2: The Supervisory Review Process
To the Basel Committee the supervisory review
process of the new framework is intended not
only to ensure that banks have adequate capital
to support all the risks in their business, but
International Journal of Excellence in Islamic Banking and Finance Page 5
also to encourage banks to develop and use
better risk management techniques in
monitoring and managing their risks. The
development of an internal capital assessment
remains the responsibility of bank’s
management; however the supervisors are
expected to evaluate how well banks are
assessing their capital relative to their risks and
intervene, where appropriate.
Four key principles of supervisory review have
been identified in the present framework.
These principles are:
Principle 1: Banks should have a process for
assessing their overall capital adequacy in
relation to their risk profile and a strategy for
maintaining their capital levels.
Principle 2: Supervisors should review and
evaluate banks’ internal capital adequacy
assessments and strategies, as well as their
ability to monitor and ensure their compliance
with regulatory capital ratios. Supervisors
should take appropriate supervisory action if
they are not satisfied with the result of this
process.
Principle 3: Supervisors should expect banks to
operate above the minimum regulatory capital
ratios and should have the ability to require
banks to hold capital in excess of the minimum.
Principle 4: Supervisors should seek to
intervene at an early stage to prevent capital
from falling below the minimum levels required
to support the risk characteristics of a particular
bank and should require rapid remedial action if
capital is not maintained or restored.
This pillar as well as the following one
constitutes a fundamental innovation in the
evolution of risk management as they bring the
supervisors and the other stakeholders at the
heart of this crucial area.
Pillar 3: Market Discipline
By setting Pillar 3 the Basel Committee intends
to encourage market discipline by developing a
set of disclosure requirements which will allow
market participants to assess key pieces of
information on the scope of application, capital,
risk exposures, risk assessment processes, and
hence the capital adequacy of the institution.
Despite its valuable contribution to the area of
risk management in the banking industry, Basel
II does not adequately cater for the needs of
Islamic Financial Institutions (IFIs). The obvious
and fundamental reason is that the framework
was designed for the conventional banks which
differ from Islamic banks in term of underlying
principles, the contracts used, and the structure
of the business. To address these issues which
are specific to Islamic finance the Islamic
Financial Services Board (IFSB) issues several
standards that we shall briefly present in the
next section.
CATERING FOR THE SPECIFICITIES OF IFIs: THE
IFSB STANDARDS
Islamic banks are established to carry out the
financial transactions in compliance with the
principles of Sharī'ah. Thus, the risk of violating
the Sharī'ah rulings is supposed to be as serious
as the risk of insolvency. In addition, the Islamic
banks use various contracts in the course of
their business, such as Mudhārabah,
Mushārakah, Murābahah , Salam, Istisnā’,
Ijārah, etc. which have different risk profile as
compared to lending with interest which is the
main contract used in the conventional banking.
It is not unusual to find different types of risks
in one of the above contracts with different
manifestations at various stages of the contract.
Furthermore, the Mudhārabah contract is used
by many Islamic banks on their liability side, to
Page 6 Volume 1 Issue 2 – September 2011
collect deposit in the form of Profit Sharing
Investment Account (PSIA). The particularity of
these accounts is that neither the capital nor
the profit is guaranteed by the banks, in
principle. The banks, as Mudhārib, invest the
funds on behalf of the depositors and share
profit with them according to a pre-agreed
ratio; any loss, not due to negligence, will be
borne by the capital. Such types of accounts are
unique to Islamic banks, and deserve particular
attention since their risk exposures are similar
to equity whereas their holders do not have the
same rights as the equity holders.
All these issues discussed above are specific to
Islamic finance and are not addressed by Basel
II accords, hence the pertinence of the
standards issued by IFSB to deal specifically
with them and therefore complement the Basel
II accords as framework for risk management
for IFIs.
IFSB has started its operations, in 2003 in Kuala
Lumpur, as an international standard-setting
body that promotes and enhances the
soundness and stability of the Islamic financial
services industry by issuing global prudential
standards and guidelines principles for the
banking, the capital markets and the insurance
sectors.
To complement the OECD and BCBS's work
relative to the banking industry, the IFSB has
issued 5 standards:
- Capital Adequacy Standard for Institutions
(Other than Insurance Institutions) Offering
only Islamic Financial Services. Issued in
December 2005.
- Guiding Principles of Risk Management for
Institutions (Other than Insurance
institutions) Offering only Islamic Financial
Services. Issued December 2005.
- Guiding Principles on Corporate Governance
for Institutions offering only Islamic Financial
Services (Excluding Islamic Insurance
(Takaful) institutions and Islamic mutual
funds). Issued December 2006.
- Disclosures to Promote Transparency and
Market Discipline for Institutions offering
Islamic Financial Services (Excluding Islamic
Insurance (Takaful) institutions and Islamic
mutual funds). Issued December 2007.
- Guidance on Key Elements in the Supervisory
Review Process of Institutions offering
Islamic Financial Services (Excluding Islamic
Insurance (Takaful) institutions and Islamic
mutual funds). Issued December 2007.
A separate analysis of these standards is
beyond the scope of this paper; nonetheless we
can remark that a due attention is given, in
these standards, to the unique risk of Sharī'ah
compliant transactions, the Sharī'ah governance
of the IFIs and the protection of the rights of
PSIA holders. In addition, a new formula for CAR
is proposed to address the issue that with PSIA
there is capital charge only for operational risk.
In addition, the appropriate weight for assets
financed by Islamic banks through the
nominated contracts is determined.
Like the Basel II framework, the IFSB standards
emphasise on the role of the local supervisors
in the process of good governance and risk
management. In Malaysia, BNM has taken
several important measures in that direction,
through the issuance of guidelines which aim to
customise the BCBS specifications as well as
that of the IFSB. In the following section we
briefly discuss some elements of these
guidelines.
International Journal of Excellence in Islamic Banking and Finance Page 7
CUSTOMIZING THE BCBS AND IFSB
FRAMEWORKS: THE BNM GUIDELINES
To address the issue of CAR calculation for
financial institutions licensed under Islamic
Banking Act 1983 (IBA) and Banking and
Financial Institutions Act 1989 (BAFIA)
respectively, BNM has issued various guidelines
which, though consistent with both BCBS and
IFSB standards, are customised to sufficiently
reflect the actual risk profile of banking
institutions operating in emerging markets
(BNM, 2001). If the standards issued by the
international organizations are just optional the
guidelines issued by BNM are to be
implemented by the concerned institutions.
In Malaysia the implementation of Basel II is
applied in 2 stages: since 2008 the standardised
approaches have been implemented while the
Internal Rating Based Approach will be
applicable from 2010.
As far as the institutions offering Islamic
financial services are concerned, we can
identify two main guidelines for the CAR
computation:
- The Risk Weighted Capital Adequacy
Framework (Basel II – Risk Weighted Assets
Computation) which is issued by the
Prudential Financial Policy Department. The
financial institutions licensed under BAFIA
are required to comply with this framework.
- The Capital Adequacy Framework for Islamic
Banks (CAFIB), issued by Islamic Banking and
Takaful Department. This framework is
meant for the banks licensed under IBA.
BNM specifies the approaches to be used to
calculate the Risk-Weighted Capital Ratio
(RWCR) by the financial institutions in each
framework. Thus, in the latter the risk
measurement methodologies for the purpose
of calculating a minimum capital requirement
to be held by Islamic banks against credit risk,
market risk and operational risk are stipulated
as follows:
(i) Standardised Approach for Credit Risk;
(ii) Standardised Approach for Market Risk;
and
(iii) Basic Indicator Approach, The Standardised
Approach and Alternative Standardised
Approach for Operational Risk (BNM,
2001).
The guideline on Pillar II of CAFIB, deals with the
Supervisory Review Process; it aims to ensure
the adequacy of the capital of Islamic banks for
their operations. The guideline emphasises
BNM right to impose higher capital
requirements or prudential standards on
individual Islamic banks in the event that the
prevailing risk profiles of such institutions are
found to be significantly underestimated. Pillar
2 guidelines, under CAFIB points out aspects of
capital adequacy assessment:
- An Internal Capital Adequacy Assessment
Process (ICAAP) to be undertaken by the
Islamic banks in accordance with the
directives of the guideline and submitted to
BNM by 30 June 2011;
- A supervisory review and evaluation of
Islamic Bank’s ICCAP (BNM, 2002b).
The guideline on Pillar III sets out the coverage
of the required disclosure for Islamic banks.
Thus, it is required from the Islamic banks to
disclose qualitative and quantitative
information with respect to credit risk, market
risk, operational risk, rate of return risk in the
banking book, management of PSIA and key
Sharī'ah governance (BNM, 2007).
Page 8 Volume 1 Issue 2 – September 2011
THE IMPLIMENATION OF BASEL II BY ISLAMIC
BANKS: THE CASE OF BIMB
This section deals specifically with the
implementation of Basel II by BIMB. Bank Islam
is the first Islamic bank in Malaysia; it was
established in 1983, under IBA1983. As on June
30, 2009 its total assets stood at RM
27,488,204,000 with total equity of RM
1,519,553,000.
Our two main sources in this section are based
on the annual reports 2008/2009 and the
interview that we had with a senior executive at
the risk management division of BIMB.
The discussion will generally follow the
structure of Basel II, with the 3 pillars.
The Implementation of Pillar 1
BIMB provides the information related to its
capital base as well as the breakdown of gross
risk-weighted assets and the various categories
of risk weights in its annual report. From there
it appears that the RWCR of the bank is 13.61%
which is above the minimum of 8% required by
Basel II. In managing its various categories of
risk the bank relies mainly on CAFIB.
For the calculation of risk-weighted assets the
bank uses Standardised Approach for credit and
market risks and the Basic Indicator Approach
for operational risk. The use of these basic
approaches is in line with CAFIB requirements
as indicated earlier. The Value-at-Risk (VaR) is
also used, internally, to measure the bank
exposure to market risk. Other approaches
proposed by Basel II are yet to be implemented
as they need the setting up of specific
infrastructure and systems. However, it is worth
noting that, BIMB is planning to adopt the
Internal Ratings Based Approach under Basel II,
and it has taken some measures towards the
enhancement of the internal rating models.
The following sub-section provides a separate
analysis of the categories of risk faced by BIMB
and the way they are dealt with.
Credit Riskiv at BIMB
Credit risk is the most important risk faced by
BIMB, as it represent 86 % of the Total
weighted asset (i.e. RM 9,619892,000 over RM
11,133,458,000). This is can be easily
understood by looking into the breakdown of
BIMB financing by contract, in Chart 1 below. It
clearly appears from there that more than 99%
of the financing are debt based, through the
contracts like Bai’ Bithaman Ajil, Murabahah,
Bai’ Al-Inah, etc. whereas the equity-based
financing (i.e. Mudhārabah) corresponds to a
tiny figure of 0.1%. On the hand, consumer
financing represents more than 66% of the total
financing portfolio (See Chart 2). This would
imply more extensive effort is needed for the
monitoring of the counterparties as their
number will be higher.
For the purpose of determining the capital
requirements under the credit risk standardised
approach, BIMB applies the ratings assigned by
the approved External Credit Assessment
Institutions.
BIMB uses a variety of risk mitigation
techniques in several different markets which
contribute to risk diversification and credit
protection. For the purpose of Asset & liability
Management the bank uses all the techniques
prescribed by Basel II, such as Gap Analysis,
Duration Gap Analysis and by hedging their
fund.
International Journal of Excellence in Islamic Banking and Finance Page 9
Chart 1: BIMB financing by contract for the year 2009. Source: BIMB annual report 2009
Chart 2: BIMB financing by business segment for the year 2009. Source: BIMB annual report 2009
In addition to the above mentioned techniques,
BIMB uses other techniques like collateral items
and guarantees which are endorsed by CAFIB as
credit risk mitigation. Only certain types of
collateral and some issuers of guarantees are
eligible for preferential risk weights for
regulatory capital adequacy purposes.
Furthermore, the collateral management
process and the terms in the collateral
agreements have to fulfill the BNM prescribed
minimum requirements (such as procedures for
the monitoring of market values, insurance and
Page 10 Volume 1 Issue 2 – September 2011
legal certainty) set out in their capital adequacy
regulations. The Bank manages also its credit
risk by monitoring its customers through their
credit cards and their way of spending and by
getting feedback on their personnel customer’s
behaviour.
Operational Riskv at BIMB
Operational risk constitutes the second most
serious risk based on its proportion in the total
risk weighted assets (11%). As mentioned
earlier, the Bank employed the Basic Indicator
Approach for the calculating the necessary
capital against operational risk.
The sources of operational risk can be either
internal (i.e. people, systems, processes) or
external, such as catastrophic events.
The Operational Risk Management Department
at the BIMB is responsible for determining the
risk profile in comparison to the bank’s risk
appetite and for deciding the risk mitigating
techniques.
Market risk at BIMB
The total risk weighted assets for market risk at
BIMB is estimated at RM 297,754,000, as on 30
June 2009 representing only 3% of the total.
Nevertheless, if not well managed this type of
risk could be the source of other risk. This is
because significant or sudden movements in
market prices and rates could affect the bank’s
liquidity/funding position. Thus, BIMB identifies
6 factors of market risk: Rate of return or profit
risk, foreign exchange risk, equity investment
risk, commodity inventory risk, displaced
commercial risk, and liquidity risk (See BIMB
annual report 2009 for more details).
As we may observe, BIMB is not exposed
directly to interest rate risk because interest is
prohibited under Islamic banking. The indirect
interest rate risk exists and arises from
competition with mainstream banks. This is
managed by regularly reviewing the Bank profit
rates as in conventional banks based on Base
Lending Rate or Based Finance Rate on a daily
basis to mitigate profit rate risk.
However, this practice is of nature to raise
some concerns. This is due to the fact that the
risk-return profile of the deposit accounts on
the liability side of Islamic banks is different
from that of conventional bank. In particular
the PSIA are similar to equity as a result, the
return to these types of account should rather
be compared to that of the equityholders not to
that on debt based products that conventional
banks offer.
BIMB holds derivative financial instruments-
which are deemed compliant with Sharī'ah to
hedge its exposure. Contracts like profit rate
swap and forward, which is based on the
concept of wa'ad (promise) and which is
binding on the customer, are relied upon to
manage the market risk
As in the conventional banking context, the
management of liquidity risk is based on various
techniques. To deal with liquidity risk, BIMB
adopts the strategy consisting of diversifying its
deposit base and at the same time lengthening
the maturity of the deposits. On the other
hand, the bank takes advantage of the liquidity
of the Islamic Interbank Money Market where it
can invest in a variety of liquid assets such as
Islamic negotiable instruments, Islamic treasury
bills, Islamic accepted bills, Islamic commercial
papers and Islamic interbank acceptances etc.
The Implementation of Pillar 2 and Pillar 3
As mentioned in the guideline on Pillar II, BNM
carries out the supervisory review process
through periodic visits to the banks. Thus, at
International Journal of Excellence in Islamic Banking and Finance Page 11
BIMB they receive visit from BNM officers at
least once a year. From time to time BNM gets
feedback from the bank on how it manages the
different types of risk it faces, and then makes
some recommendations if necessary.
The BIMB annual report provides a breakdown
of the types of assets and their amounts as well
as that of the deposits. As required by the BNM
guideline on Pillar III, general information on
capital, risk exposures, risk assessment
processes, and the capital adequacy of the
institution are disclosed. However, as
mentioned earlier, the presence of PSIA on the
liability side of IFIs renders it necessary to make
additional disclosure on matters pertaining to
them. Thus, in the annual report the different
types of PSIA, their amounts, the profit
attributable to them as well as the amount of
Profit Equalization Reserve (PER) are made
public.
One of the major issues related to the
implementation of Basel II is the lack of experts
able to elaborate and interpret Basel
requirements; this becomes particularly
relevant if we take into account the various
nature of banks' specialization. The current
practices mainly rely on micro soft excel, while
application of Basel II needs highly
sophisticated infrastructure of IT and advance
system to measure the daily volatility which is
not available currently in BIMB systemvi.
CONCLUSION
In this paper we have studied the
implementation of Basel II by Bank Islam which
is the first and biggest full-fledge Islamic bank in
Malaysia. We have attempted to provide an
overview of the regulatory environment for this
Islamic bank which shares most of the risks that
conventional banks are faced with, in addition
to its unique risks. To address the particularities
of Islamic Banks, BNM has come up with
specific guidelines that combine between the
Basel II accords and the IFSB standards with the
necessary customization.
We have found that BIMB is well capitalised and
is using the standardised and basic indicator
approaches for the calculation of risk weighted
assets. This can be explained by the fact that
BNM allows the use of IRB starting from 2010
but also by fact that BIMB lacks the required
infrastructure to use the advanced approaches.
Among all the 3 types of risk that require capital
for their management in the context of Basel II,
credit risk is the most important at BIMB, as its
proportion in the total risk weighted assets is
more than 86%. This can be explained by the
overreliance of BIMB on debt instruments in its
financing activities, corresponding to more 99%,
while equity based financing represents 0.1%.
We believe that the management of the asset
liability mismatch would be less problematic for
the Islamic Banks if partnership contracts
namely Mudhārabah and Mushārakah were
successfully implemented on the asset side as
they are on the liability side. But for that,
important changes are needed in the
environment and the attitudes. Two common
reasons are usually advanced by practitioners
to justify the small portion of partnership
contracts on the asset side of Islamic banks:
- Established companies with good business
prospects prefer debt financing that allows
them to benefit from the profit enhancing
feature of leverage. Hence, only risky
customers, like start-ups, would be willing to
go for Mudhārabah or Mushārakah
financing.
- In its standard on Capital Adequacy, IFSB
requires a risk-weight of 400% (equivalent to
a capital charge of 32%) for equity exposures
(i.e. Mudhārabah/Mushārakah based
Page 12 Volume 1 Issue 2 – September 2011
financing in the banking book) in private and
commercial enterprisevii. This capital charge
is considered very high compared to other
that required for other modes of financing.
The first argument seems to be well grounded.
However, by undertaking structural changes
Islamic banks may set up specialised units with
qualified main power carry out the financing of
small and medium enterprises based on
partnership contracts. The unit would carry out
all the necessary screening and following-up
required by such a type of financing.
As for the second argument, we are of the view
that it is not convincing. First, while more
capital charge is required for the equity
exposures in the banking book, Islamic banks
are qualified for capital relief with all assets
financed based on Mudhārabah deposits, since
only operational risk is accounted for.
Furthermore, the critical role of banks in a
financial system, the requirement of higher
capital charge for asset financed through
partnership contracts makes sense as it is of
nature to prevent the banks to use take on risky
projects without rigorous screening when its
capital stake is small.
REFERNCES The Basel Committee for Banking Supervision, 2004. International Convergence of Capital Measurement and Capital Standards: A Revised Framework, 2004. Available at: www.bis.org. The Basel Committee for Banking Supervision. International convergence of capital measurement and capital standards: A revised framework, comprehensive version, 2006. Available at: www.bis.org. The Basel Committee for Banking Supervision. International framework for liquidity risk measurement, standards and monitoring, 2009.
Consultative document available at: www.bis.org. The Basel Committee for Banking Supervision. Strengthening the resilience of the banking sector, 2009. Consultative document available at: www.bis.org. Bank Negara Malaysia. Risk Weighted Capital Adequacy Framework (Basel II-Risk Weighted Assets Computation), BNM/RH GL001-22, 2001. Bank Negara Malaysia. Capital adequacy framework for Islamic banks. BNM/RH/GL/002-14, 2002a. Bank Negara Malaysia. Capital adequacy framework for Islamic banks – Internal capital adequacy assessment process (Pillar 2). BNM/RH/GL 002-22, 2002. Bank Negara Malaysia. Capital adequacy framework for Islamic banks – Disclosure requirements (Pillar 3). BNM/RH/GL 007-18, 2007. Gallati, R. Risk management and capital adequacy. New York: McGraw-Hill, 2003. Islamic Financial Services Board. Capital adequacy standard for institutions (other than insurance institutions) offering only Islamic financial services, 2005a. Available at: www.ifsb.org. Islamic Financial Services Board. Guiding principles of risk management for institutions (other than insurance institutions) offering only Islamic financial services, 2005b. Available at: www.ifsb.org
Islamic Financial Services Board. Guiding principles on corporate governance for institutions offering only Islamic financial services (excluding Islamic insurance (Takaful) institutions and Islamic mutual funds), 2006. Available at: www.ifsb.org.
Islamic Financial Services Board. Disclosures to promote transparency and market discipline for
International Journal of Excellence in Islamic Banking and Finance Page 13
institutions offering Islamic financial services (excluding Islamic insurance (Takaful) institutions and Islamic mutual funds), 2007a. Available at: www.ifsb.org. Islamic Financial Services Board. Guidance on key elements in the supervisory review process of institutions offering Islamic financial services (excluding Islamic insurance (Takaful) institutions and Islamic mutual funds), 2007b. Available at: www.ifsb.org. Ikkizidis, I. and Khandalwal, S.K. Financial risk management for Islamic banking and finance. New York: Palgrave macMillan, 2008. Kahf, M. Basel II: Implications for Islamic banks. In: Jakarta, Indonesia the 6th International conference: Islamic Economics and Banking in the 21th Century, Jakarta, Indonesia 21-24 November 2005. Khan, T. and Ahmad, H. 2001. Risk management an analysis of the issues in Islamic financial industry. Occasional Paper no.5. Jeddah: IRTI, 2001. http://www.pdf-finder.com/RISK-
MANAGEMENT-AN-ANALYSIS-OF-ISSUES-IN-ISLAMIC-FINANCIAL-INDUSTRY.html Wignall, A. and Atkinson, P., 2010. Thinking beyond Basel III: Necessary solutions for capital and liquidity. OECD Journal: Financial Market Trends, 2010(1).
Online Resources:
http://www.bankislam.com.my
http://www.bnm.gov.my/index.php?tpl_id=118&lang=en&qt=CAFIB
http://www.islamicpopulation.com
i In December 2009, BCBS released 2 consultative
documents that are meant to address some issues in the
banking sector that were identified as aggravating factors
during the crisis. These documents are:
- International framework for liquidity risk
measurement, standards and monitoring; and
- Strengthening the resilience of the banking sector.
ii The discussion in this part and the following mainly
refers to BIS (2006).
iii Tier 1 comprises, among others, the following items:
Ordinary paid-up share capital, share premium, statutory
reserve fund, general reserve fund, retained profits
brought forward from previous financial year as in last
audited accounts less any accumulated losses, including
current unaudited losses, etc. However, if the new
framework is adopted, the predominant form of Tier 1,
will be common shares and retained earnings. And Tier 2
comprises hybrid (debt/equity) capital instruments,
subordinated term debt, subject to the prescribed limit,
reserves arising from the revaluation of premises, etc.
iv Credit Risk arises from all transactions that could lead
to actual, contingent or potential claims against any
party, borrower or obligor. BIMB recognizes four kinds of
credit risk in its portfolio: Default Risk, Settlement Risk,
Country Risk and Contingent Risk (BIMB annual report
2009).
v Operational risk can be defined as the risk loss arising
from inadequate or failed processes, people, systems and
external events. It also includes legal risk and Shari`ah
non complaint risk but excludes strategic and
reputational risk (BIMB annual report 2009).
vi An officer from BIMB or update us during the LIFE2
Conference that the bank has made important
investment to acquire the needed sophisticated system.
vii
Upon the permission of the supervisors, the bank may
use the ‘Slotting Method’ which requires less capital
charge.