Islamic banks take on Basel III

Q: What are the long-term implications for profit-sharing investment accounts [PSIAs] under Basel III?

Mohamed Damak: In terms of implications, I think the most important aspect of this question is the treatment of the PSIAs under Basel III in relation to the liquidity coverage ratio, which needs to be clarified. The Islamic Financial Services Board [IFSB] is working on the guidance now, which is expected to be published in early 2015. I think one of the main issues there is the run-off rate that would be applied to the PSIAs, factoring in their possible loss-sharing characteristics and the impact this might have on their stability. The higher the run-off rate, the higher the liquidity needs and the lower the net stable funding eligibility of the PSIAs.

In terms of the consequences it could have on the PSIA, it could either result in lengthening the maturity of the PSIA or it could lead to penalties for a withdrawal, although it is unclear whether this would be sharia-compliant.

Khalid Hamad: Basel III is being implemented during a low-growth economic environment. This situation, coupled with current low interest rate levels and the expected liquidity impact on Islamic banks, will lead to a reduced profit rate for Islamic banks. However, for restricted PSIAs, we see no implication as assets funded by such accounts are not affected by Basel III, at least in Bahrain.

Tirad Al-Mahmoud: In general, Islamic banks should be well positioned to meet Basel III requirements because most have very strong balance sheets and are rooted in relatively fast-growing economies in the Arabian Gulf and south-east Asia. Their balance sheets are largely clear of derivatives and complex, risky assets. This facilitates compliance with Basel III's minimum capital standards. However, one challenge may arise on how PSIAs are treated by national regulators as Basel III is implemented. The treatment of PSIAs under the new regime will rely largely on the views taken by national regulators, who will be tasked with applying different weights to funding sources, including PSIAs.

In my opinion, PSIAs that are designed to be commercially competitive and fairer to depositors should be looked at for their historical stickiness characteristics. They should be considered as stable deposits, and should therefore be exempt from the stipulation on volatile assets needing sufficient high-quality liquid assets [HQLAs] to cover net cash outflows. I am sure that the regulators will come up with a fair solution on how to treat PSIAs, and a note issued by the IFSB – a global standard-setting body in Malaysia – will be of significant value to help regulators decide how to treat PSIAs.

Muzaffar Hisham: I think that the approach taken by the central bank of Malaysia in the new Islamic Financial Services Act of 2013 is the correct one. It provides a clear demarcation between what it calls a guaranteed deposit and an investment account. I find it is very positive because it is based on the right form of disclosure and the right structure in terms of portfolio management, and we can enhance the possible returns to investors and also share the risk-weighted assets between the investors and financial institutions. Moreover, I support the governor of the central bank of Malaysia’s point of view in terms of shifting Islamic finance from a credit intermediary to an investment intermediary.

Maybank Islamic is embracing this perspective and we have put up a number of proposals to the central bank to push this agenda forward. It will create a degree of capital efficiency for the industry and provide a competitive edge for Islamic banking.

Q: What are the prospects for the greater uptake of Islamic deposit insurance in light of Basel III?

MH: The standards of deposit insurance in Malaysia are similar to the standards of the conventional banking space. It’s a question of the deposit insurers being very clear about the type of risks that are likely to emerge in either the conventional or Islamic financial sectors. I’m encouraged by their approach in Malaysia and I hope they continue to do that because risk management should not differentiate between Islamic and conventional finance, it just requires an understanding of the different types of risk that can emerge. We want to see a level playing field between the two financial sectors.

MD: The prospects for deposit insurance are positive because of Basel III and I think the deposit insurance can contribute to a lowering of the expected run-off rate. However, this will depend on the scenarios to be covered by deposit insurance. For example, would deposit insurance cover a situation where a bank would have to cover losses for PSIA holders because of bad profitability? This is something to be determined by the national regulators.

TM: This is another issue that Islamic banks will face when it comes to Basel III. For bank deposits to be deemed stable, they need to be protected by an insurance scheme, but sharia-compliant schemes are rare, partly because government support for domestic banks is considered implicit in many Gulf countries. Therefore, it’s important for Islamic banks to come together to develop a form of deposit insurance on a takaful basis, where the premium must be paid by the depositors.

I know some work has already been done in certain countries. For example, Bahrain introduced Islamic deposit insurance in 1993 and Qatar has said it is in the process of developing an Islamic deposit insurance scheme. In June, Bangladesh announced that Islamic deposits would be covered under an existing scheme managed by the central bank.

KH: There is no direct link between the two other than the likelihood that Basel III they will lead to a risk reduction for the financial sector and hence the risk premium associated with deposit insurance should trend down accordingly. If a country implements a deposit protection scheme for conventional banks then it will be unwise to leave the Islamic banks’ unrestricted investment account-holders unprotected. It is also against the principle of providing a level playing field between sharia-compliant and conventional finance.

Q: To what extent will the implementation of Basel III incentivise the creation of a broader range of HQLA for the Islamic finance market?

TM: A potentially very positive outcome of Basel III could be the deepening of the market in Islamic securities, with Islamic banks emerging as strong drivers of demand – just as conventional banks globally are important buyers of government securities. At present, the supply of eligible high-quality liquid securities remains fairly limited, and we do not see the depth of issuance and variety in maturity that is really needed.

There are good historical reasons for this – for example, the Gulf governments have been running surpluses for several years, and have not really needed to issue a great deal of sukuk or conventional bonds. However, the adoption of Basel III liquidity rules may well spur a change. With demand from banks growing, sukuk yield spreads could well tighten and encourage greater issuance from sovereigns. 

Additionally, central bankers are also showing that they are keen to structure repo or equivalent transactions for Islamic banks, which will also create depth and liquidity in the money markets.

KH: The shortage of high-quality liquid instruments has been a key issue facing Islamic banks. Basel III is likely to act as a trigger to incentivise and push Islamic banks and sovereigns to issue more sukuk and other sharia-compliant papers. There are some encouraging signs of healthy innovation in this area with the introduction of perpetual sukuk by some Islamic banks. If Islamic banks fail to meet this challenge they will not be able to maintain their full compliance with Basel III liquidity requirements and/or suffer a reduction in returns resulting in inefficient use of capital.

MD: I think this is a great opportunity that Basel III is creating to help resolve this long-standing issue facing the Islamic finance industry. We have been talking about the lack of liquidity management instruments for Islamic finance for almost a decade. Today some of the world’s central banks have recognised this weakness and have started to remedy this problem. The central bank of Malaysia issued $50bn in short-term sukuk in 2013 making it the largest issuer in the world.

And I think today with Basel III, it is not only central banks, but also sovereigns, corporates and multilaterals that may be incentivised to issue either short-term sukuk or to list their sukuk on markets to make them eligible for HQLA inclusion. In any case, a decision on whether or not to include an asset as high quality resides with national regulators.

MH: I can foresee the development of more HQLAs if they are needed in a specific jurisdiction. I think regulators should not be over zealous when applying a one-size-fits-all policy to various markets. Each jurisdiction has different types of objectives and economic policies. I hope regulators look at Basel III as a guide and as a benchmark, and the specific national regulators will apply that accordingly to the need of the policies of the country.

My concern is that just because we would like to follow Basel III, including certain liquidity coverage ratios, it may be counterproductive if not applied according to the specific requirements of the market. As such, one ratio is not fit for all. It must be applicable in terms of the timing of the implementation to the needs of each economy. I hope that regulators, rather than just following Basel III, are focused more on the various types of robust stress testing.

Q: Given that national regulators will have a degree of discretion when applying certain Basel III standards, particularly when defining sharia-compliant financial products, how important will their role be in ensuring the industry stands to benefit from Basel III over the long term? 

MD: I think it’s going to be extremely important and the challenge for the national regulators is to have a definition that would more or less mirror that of the Basel Committee on Banking Supervision while at the same time creating an incentive for the development of HQLA. I think a large portion of the solution rests with them and I think the issuances of the central bank of Malaysia in recent months are an example of that. I think for those who decided to adopt Basel III will need to put in place an enabling environment and the necessary instruments for their banks to adopt Basel III.

TM: I think regulators are aware of the growing importance globally of Islamic finance and the fact that it is no longer just the domain of Muslims but gaining ground because of a wider desire for a financing model rooted in the real economy. In the United Arab Emirates, Islamic banks are attracting many non-Muslims. And in capital markets, conventional issuers from the UK, Luxembourg, South Africa and Hong Kong are getting in on sukuk.

Because of this, many countries are very accommodating to the development of the Islamic finance industry. I would urge them to continue to think ahead. Islamic financial assets are currently growing at the rate of about 15% annually at a compound rate, so in only five years, the industry will have doubled.

KH: Basel III implementation will lead to an improvement in risk management practices and better governance. It will also force the banks to restrict themselves to the core of their business. Regulators have a duty to oversee that the implementation is done in letter and spirit in order to achieve these benefits. In particular, the use of exceptions and waivers should be discouraged unless there is a compelling reason for it. 

MH: The role of the national regulators is vital in terms of finding the correct balance between regulation and trusting the market. This is a very delicate issue. Imagine if a regulator suddenly imposed a high capital requirement on a market without looking at the consequences on the growth of the banking sector and whether the outcome will impact the confidence of the market. That’s where the danger lies. So there might be a scenario where high capital requirements are imposed on the banks and as a result they will feel the pressure on their net income margins and their return on equity. So there must be a balance. If that effect translates into lower confidence levels in the banking system, it will have significant and negative consequences for the financial sector as a whole. 

Q: What impact will the introduction of the counter-cyclical and capital conservation buffers, in particular, have on Islamic banks? How can this help to strengthen capitalisation, given that exposure to the real estate sector among Islamic banks remains high?

KH: The capital conservation buffer will lead to restrictions on dividends and bonuses. This will contribute towards improving investment and credit decision making leading to better utilisation and maintenance of capital. Exposure to real estate by Islamic banks has been decreasing in size and slightly improving in terms of quality of existing exposures. Any further increase will attract a higher capital charge.

For example, in Bahrain the risk weight for any exposure to real estate is 200%. In terms of the counter-cyclical buffer, its impact is yet to be assessed as the method for calculating it is under development in most countries. However, the philosophy is similar to the one that Islamic banks are familiar with and have been following in the case of PSIAs, for example, investment risk reserve and profit equalisation reserve.

MD: The introduction of these two buffers will reinforce the capitalisation of Islamic banks and make them more resilient to the cyclical swings by requiring additional capital in front of the risks they take. Because of the asset-backing principle in Islamic finance, Islamic banks tend to be highly exposed to the real estate sector compared with their conventional counterparts. This could put them in a difficult position in case of a correction in the real estate sector, for example.

In the same vein, Islamic finance today is concentrated in emerging markets. More than 80% of the assets of Islamic banks are concentrated in the Gulf Co-operation Council region and Malaysia alone. These countries are less stable than developed economies and more prone to cyclicality, so increasing the capital requirements for Islamic banks will certainly enhance their resilience. Where Basel III will have a neutral impact on Islamic banks is on the quality of capital.

TM: The counter-cyclical and capital conservation buffers are a positive development, given the boom and bust experience in the recent past. But there’s not a great deal of difference between Islamic banks and conventional banks in this regard. Islamic banks have tended to be less vulnerable to financial bubbles than their conventional counterparts because of limited exposure to derivatives.

However, exposure to real estate – the archetypal cyclical sector – tends to be relatively high, and this is especially the case in rapidly developing economies, such as the Arabian Gulf. This region’s economy is also largely driven by government investment, based on budget surpluses fuelled by hydrocarbon exports, although economic diversification is gathering serious momentum. In the past, such investment has been impacted by fluctuations in oil prices, although several years of surpluses now mean that volatility in government spending, and therefore in the wider economy, has been curbed.

MH: In these instances it should be risk neutral, be it conventional or Islamic. I think the devil is in the detail. The regulators and the banks need to understand the types of risk to have the right kind of dialogue about the types of investments they are involved in. I don’t think there will be a major difference between Islamic and conventional banks in this regard, but the policy-makers do need to be mindful of the types of investments that Islamic banks are involved with. Islamic banks are generally asset backed, which is a positive point, but if a bank has a portfolio comprised of 80% real estate assets, that isn’t healthy.