As banks prepare for the impact of Basel III regulations, many Islamic financial institutions are finding they already exceed the requirements.

With above-average Tier 1 capital, strong customer deposits and much lower levels of leverage and trading book risks, well-managed Islamic banks will not be looking for additional capital. So, does this mean that Basel III regulations will not affect Islamic banks in the same way they will conventional banks? Bankers are not so sure.

For a start there is the issue of liquidity. Despite apparent progress towards improving Islamic liquidity through increased sukuk issuance, for instance, there remains a lack of eligible liquidity instruments and adequate central bank facilities. This gap in the market would have to be filled to make Basel III compliance possible. 

And Islamic banks have not been spared by the global financial crisis, which prompted G-20 leaders to focus on regulations aimed at improving the quality of bank capital. Many were exposed to risky expansion plans and high-risk concentrations, in particular in the real-estate sector.

Limited exposure

Islamic banks are traditionally small, with limited cross-border exposure. They are not "playing with the big guys", in the words of one London-based banker. Mike Kennedy, head of risk at Bank of London and the Middle East, says that while the sector remains small, it is experiencing rapid growth. Thanks to its sound fundamentals, the bank has not been exposed to the high-risk investment that weakened conventional banks.

Even so, improving standards and complying with Basel III remain sensible measures for banks to take in the light of the crisis. Mr Kennedy considers the framework necessary, even if bankers have often found it over-complicated. “It’s difficult to see the wood for the trees, but there is no doubt [that] after the global crisis, Basel III became a necessity,” he says.

Despite some exposure to poor quality assets, in general, Islamic banks’ capital structure, which is dominated by Tier 1 capital in common equity form, means few were exposed to the excessive risk of conventional banks. According to Mr Kennedy, on average 80% of Islamic banks' capital is Tier 1. In the case of Bank of London and the Middle East, that figure is a staggering 99%.

Not conventional

Most sharia-compliant institutions also have considerably higher capital adequacy ratios than conventional banks. Islamic finance offers limited options to raise alternative forms of capital and so results in a lack of subordinated debt in sharia-compliant form, as well as fewer preference shares.

The capital structures and above-average capital ratios of Islamic financial institutions puts them in a favourable position compared with conventional banks. And while Islamic banks are limited in their scope of capital-raising instruments, this has sheltered them from the problems faced by conventional banks.

Sharia-compliant banks' limited use of derivatives and securitised structures will benefit their levels of capital adequacy. In addition, these banks will remain immune from the costs needed to address the inherent risks in such products. Also, the lack of leverage in most Islamic banks means they will not be impacted by the leverage ratio of Basel III.

Liquidity alert

While liquidity can be an area of concern for both conventional and Islamic banks, the impact on operations is likely to be different between the two sectors. 

Conventional banks knew their profitability would be hit by the new regulations soon after Basel III was agreed. Dr Lawrence Galitz, CEO of financial training company ACF Consultants, issued a warning to the City of London in October last year, predicting profits could fall by up to one-third after the introduction of Basel III in 2013.

“Several banks recently complained to regulators about the negative impact Basel III will have on their profits,” said Mr Galitz. “We have been saying this since they were announced six months ago. Basel III may force banks to widen their margins and put up the cost of lending and if it’s going to cost banks, it’s going to cost the consumers, too.” 

Smooth transition

For Islamic banks, however, the transition is hardly expected to dent profits. According to Haroun Dharsey, senior vice-president at Dubai Islamic Bank, the sector is well prepared, thanks in part to the principles that underpin Islamic finance, which are similar to the regulatory framework.

The Basel III Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand periods of stress, bringing the total common equity requirement to 7%.

Islamic banks are among the best capitalised banks in the world, and historically comply with inflexible standards of capitalisation. This means that many Islamic banks already exceed norms set by the Bank for International Settlements as part of the Basel III accord. “Islamic banks already operate under similar guidelines and will therefore have few measures to undertake once Basel III is fully operational,” says Mr Dharsey. 

Aligning regulations

Consensus has also been reached among bankers. Sharia-compliant banks agreed to align their regulations with Basel III reforms as far back as December 2010. Rifaat Ahmed Abdel Karim of the Islamic Financial Services Board (IFSB), says they were in the process of amending their regulations as per Basel III and this is expected to be completed in 2013. “We are revising the standard of capital adequacy to look into any need for more capital and in what form that additional capital [will] be,” he says.

Islamic banks fared well during the crisis and have strong capital bases, but they are still open to improving things further. In doing so, Islamic banks will need to consider whether their strategic, business and product-specific decisions take sufficient account of the inherent uncertainties and opportunities caused by the increasing complexities of financial markets.

The Kuala Lumpur-based IFSB, whose members include central banks and the International Monetary Fund, is one of two standards-setting bodies that issues guidelines on sharia-compliant financial institutions, capital markets and insurance sectors. Mr Abdel Karim says the IFSB's liquidity management corporation will provide a substitute for a commodity ‘murabaha’ money market instrument by issuing short-term Islamic finance instruments to help lenders manage liquidity position. “This will hopefully give depth to the capital market,” he adds.

Simpler, easier

Ultimately, the principles of Islamic finance protect it from the excesses seen in conventional banking. The structure of Islamic banking is simpler, more tangible and easier to understand in many ways. These attributes are strengthened by sharia boards headed by scholars who only approve new deal structures and business activities if they comply with sharia principles.

As the international financial community comes to terms with the effects of its risk-hungry industry, there is a growing trend among bankers to adopt a similar ethos to that of Islamic banking. Thanks to their levels of Tier 1 capital, stable funding models and strong customer franchises, Islamic banks will find that their net margins and borrowing costs are less adversely impacted than many larger diversified and leveraged conventional banks.

Basel III is unlikely to fundamentally change the way Islamic banks operate. Indeed, they have more immediate challenges, such as consolidation and increasing profits. But for some Islamic banks, the regulatory framework will offer an opportunity to prosper and strengthen their positions.

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