Capital Adequacy Ratio

IBRC100

Page to full collection of articles appearing in the Borneo Posts

While I like to think that I know a sizeable amount of Islamic Banking regulatory literature, I have to admit to procrastinate when it comes to the “ratios in Islamic Banking”. It started with the Liquidity Coverage Ratio guidelines issued about 2 years ago, and also the Capital Adequacy Framework for Islamic Banks, which I promised myself to read by September. And all I know about the Tier 1 Capital is that this capital allows you to continue business in event of losses while Tier 2 Capital is used in a winding up scenario. I know where my gap in knowledge for this topic.

So, finding this little gem written by  Dr Hanudin on the above is a real treat. Reminds me that there is still a whole topic to be digested and written about. Below is the extract, and you can find the full article in his page on this website. (Click Here)

Understanding CAR in the context of Islamic banking

Published by The Borneo Post (Sabah), 19th June 2017

By Dr Hanudin Amin

Extract:

BANK capital serves as a liquid bulwark to warrant the smooth operations of both Islamic and conventional banks, turning the banks into a better likelihood of endurance in the banking market. In general, a bank capital is viewed as the source of funds provided by the owners of the bank, which acts as a cushion to thwart a bank failure’s occurrence.

         This week I draw your attention pertinent to capital adequacy ratio (CAR) in the context of Islamic banking. For this purpose, three questions are answered using an analytical technique: Question #1 – What is meant by the term CAR?  Question #2 – What makes CAR’s components? Question #3 – Does an Islamic bank have a better CAR?

 By definition, CAR is a measure of the amount of the capital owned by the bank that typically captures Tier 1 Capital and Tier 2 Capital and are divided by risk-weighted asset (RWA). CAR plainly acts as an enabler to protect depositors of CASAFA (i.e. current account, savings account & fixed account) in which their deposits are principally guaranteed for consumer protection. In addition, CASAFA is also subject to Malaysia Deposit Insurance Corporation’s (MDIC) protection up to MYR 250,000 limit per account includes both the principal amount of a deposit and the interest/return, separately applied to Islamic and conventional deposits.

For the full article, click on the following link: Understanding CAR in the context of Islamic banking – Borneo Post 19th June 2017

Go to Dr Hanudin’s page : click here

Happy reading & have a good remaining Ramadhan ahead.

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Disruption : Islamic Contracts

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Under IFSA 2013, it is no longer about Product Innovation. It is about Product Compliance.

2 weeks ago I had a session with some bright individuals discussing the Islamic contracts commonly used in Corporate Banking financing structures. We went through almost all the available Islamic financing contracts such as Murabaha, Ijara, Musyaraka and Mudharaba, where I highlighted that all these contracts now have their own Policy Document issued by Bank Negara Malaysia (BNM). The Policy Documents, in my opinion, are a concise version of a lot of Sharia regulations and great reading source. It becomes a reference point where management roles and responsibilities are outlined, operational behaviour laid down, and theoretical basis is justified and explained.

It is a matter of time, I told the participants, that these Policy Documents are taken in their full context and finally developed into a comprehensive structure with clear compliance to Sharia requirements. We, as Islamic Bankers, are in for an exciting period of development where we will have a chance to develop “real” Islamic banking contracts.

The moment I said that, I realised it is NOT TRUE!!!

THE IMPACT OF IFSA 2013

The popular belief is that IFSA 2013 is meant to realign all the Islamic Banking regulations in the Islamic Banking Act, Takaful Act and various major guidelines into a single overarching Act. IFSA 2013  consolidates the various practices into more clarity and re-classification of concepts. However, the perception that Islamic Banking in Malaysia as an innovative development hub would no longer hold true. “Innovation” was the key thinking and pride-point prior to IFSA 2013; now I believe the right word is “Compliance”.

163170_477596024332_7522334_nWhen we first started the Islamic Banking journey in late 1990’s and early 2000s, BNM encouraged a lot of product innovation from Banks as there were no existing guidelines. We looked at the various structures that provides the desired outcomes and discussed with Shariah Committee on the design and component of products without breaching Sharia rules. BNM was supportive on us developing these “innovative” products. Some may have been controversial (such as Bai Inah, Bay Ad Dayn, Wadiah and Bai Bithaman Ajil) but it encourages discussions alongside the mantra that “whatever is not explicitly prohibited, is permissible“. Sometimes we were forced to think outside of the box, especially for sophisticated products mirroring conventional. We also received support from Sharia Committees whom temporarily approved “innovative” products with the understanding that over time, a better solution were developed as replacements.

Now with the issuance of the Policy Documents, such innovation becomes limited. Innovation is now ring-fenced around compliance to Shariah rules (either from regulators or internal Shariah Committee), and the Banks are expected to follow these rules to the letter. Breaches to these rules becomes the responsibility of the Bank’s Shariah Committee and detailed deliberation is greatly expected to provide the solution. Compliance first; if it is not covered in the documents, it probably cannot be done without a lot of effort.

CHOOSING THE SIMPLEST ALTERNATIVE

With compliance now being the vogue vocabulary with BNM, Banks had to look hard to the Policy Documents to ensure the requirements are identified and gaps filled for fear of breaches or fines. The gap analysis falls into the line whether “are we complying to the requirements?” and not “how do we do this without it becoming a gap or compliance issue?”. Both Shariah and Bank’s Product teams would now look on how to comply with Policy Documents instead of using the Policy Documents as a reference to develop a product.

What I noticed since 2014 is the obsession to comply with Islamic contract requirements, and if the team feels it is difficult to comply, the next logical step is to avoid such contract altogether and seek an alternative contract which is easier to comply with. For example, the Murabaha Policy Document issued in 2014. I have to say it is a beautiful document, and outlines the requirements for Murabaha Purchase Orderer (MPO) that reflects the full Sharia requirements of ownership transfers, risk taking, profit and management of actual assets.

These requirements, which in the eyes of many Banks, may be difficult to fully comply with due to many reasons: shortage of expertise, systems infrastructures limitation, people understanding, complicated processes, operational risks, credit issues and fund management requirements. Instead of the risk of breaching the Policy Documents, Banks opt for something less “complicated” which offers “similar” structure. The default solution is Tawarruq Arrangement i.e. Commodity Murabaha.

Or, the teams looks at Ijara Policy Document. It outlines further the roles and responsibilities of lessor and lessee, while the asset remained in the Bank’s ownership throughout the lease tenure. Again, if a roadblock occurs where a Bank cannot fully comply… Tawarruq Arrangement provides a quick solution. With very defined rules outlined in Tawarruq Policy Documents, the Banks are confident that offering Tawarruq will not breach any guidelines.

Tawarruq, therefore becomes the default Islamic contract in the market. When I asked the participants during case-studies to the question “What contracts should be used for this structure?”, the answers are unanimous “Tawarruq”. And they are not wrong.

DISRUPTION IN ISLAMIC CONTRACTS

155228_469014969332_6259944_nMaking Tawarruq as the “all-problems-solved” structure is having an unfortunate result to the industry. While the issuance of the Policy Documents as a reference was to galvanise the development of various Islamic contracts, the Banks have an easy way out in Tawarruq. Now, the rest of the contracts are in danger of being sidelined in favour of continuous development in Tawarruq.

For example, the Home Financing product which had evolved from BBA in the 1980s to Diminishing Musharaka in the 2000s. When BBA was introduced, practitioners and Sharia teams identified several practical issues that over a period of time needed to be resolved such as ownership transfer, rights to sell, and sale of properties under construction. These issues led to the development of Diminishing Musharaka as an alternative solution.

But with Diminishing Musharaka, there are still operational and legal issues that have yet to be resolved until today. For example, the “right” contract to be used for period of construction, the application of Ijara and the extensive outlining of Wakalah roles and responsibilities. Failure to understand the issues and provide real solutions puts the Bank at risk. There are also legal infrastructures that have yet to be addressed such as land joint-ownership by the Bank (as a partner), and different practices of land offices for the registration of Bank as a partner. These are roadblocks (and credit risks) to the Banks to take the structure further.

THE DOUBLE-EDGE SWORD OF TAWARRUQ

25547_378676189332_2665364_nMalaysia is in danger where I foresee that one day the industry itself will became the absolute global expert in Tawarruq and Commodity Murabaha. With Bursa Suq Al Sila as the leading commodity trading platform for the country, backed by the government (as a national bourse), the Tawarruq structure is expected to evolve into an efficient Islamic-structure engine. The processes of Commodity Murabaha will become seamless, and may even integrate into a Bank’s core banking system, the operation for buying and selling commodity will become commonplace and familiar, and this will result in effective processing, awareness of Shariah risks, compliance to trading requirements and well as reduction in overall operational risks.

Banks will one day become so well versed in Tawarruq, they will question the need for other types of Islamic contract, where they may not able to fully comply with.

With such development, more and more:

  1. capital investments will be made into perfecting the Tawarruq infrastructure, and Banks will also be able to comply with BNM requirements by investing in human capital familiar with Tawarruq.
  2. product structures will be developed around Tawarruq and once these products are established, it will be difficult to unwind as a prefered product simply due to the ease of the Tawarruq contract requirements.
  3. variations and hybrid products will be introduced based on Tawarruq, or containing elements of Tawarruq to solve “difficult scenarios” for compliance.

We will one day have an innovative and world class Tawarruq product, but no development in the other major Islamic contracts. Innovation will stall and Banks will choose quick returns and operational ease of Tawarruq. It is a dilemma of the industry where it is heading to “one” major solution for almost all “sale-based products”.

It is unfortunate if Banks chose to abandon the other contract alternatives, where such contracts will never reach its full operational and theoretical potential.

Hoping that a Bank will take the lead to develop products based on all the various Policy Documents instead of relying on only Tawarruq and its variations. The industry needs expansion and enhancement and by focusing on only Tawarruq, the industry will not be able to explore exciting products and expand its horizon. The Policy Documents, as beautifully written as they are, may tragically one day just becomes an academic relic issued by BNM.

Wallahualam.

Earlier writings on Tawarruq and Commodity Murabahah:

  1. Reliance on Commodity Murabahah
  2. Financing : Commodity Murabahah and Tawarruq

Interesting article in LinkedIn

Life as an Islamic Product Developer

Recently I have been asked on the function of developing Islamic products for the Bank, from one keen graduate looking to start a career in the industry. The graduate was not confident in the future of the industry and was seeking some advice.

 As a career choice, Islamic Banking remains a good option for many reasons. In my view, the industry is still a growing space, with discussions and researches still being done and far from finished. Slowly scholars are going to the forefront, and arguments on structures are becoming more sophisticated. So, it is an exciting time to be in the industry.
But how about product development itself? Is it worthwhile to enter this fray?

Life as an Islamic Banking product developer is not easy. Simply because not many knows what we are doing, and what it takes to be one. I always viewed being a product developer is as hard as being an imam in a community; you hold on your shoulders the responsibility of launching a product that the community must trust to be Shariah compliant. There is no heavier burden than this, and you must be willing to shoulder this responsibility. Not everyone willingly do this.

Eye of the Storm Product Developer

But being a product developer has its intrinsic advantages. Rarely a position in the Bank affords you access to all types of functions. As a developer who have to design, develop and launch an effective and successful product, you need to engage ALL parties in the Bank as your product needs to flow throughout the organisation. The detail involved is enormous and you are expected to be an expert in most of the touch points. Hard questions are asked by stakeholders in the Bank, and you are expected to be able to satisfactorily answer these. They won’t sign off the approvals if you fail this.

That’s why sometimes it takes a long time to develop and launch a product. Many people criticise us for being slow, unresponsive or too technical. But to reach the stage we can satisfy all parties, including Shariah Committees and Central Bank, a product will just remain a concept that is not developed and launched if we do not have a capable team that interacts effectively with all stakeholders.

In addition, Product Development requires us to be experts in various fields after a product is launched. This includes after sales support and damage control, especially if there were mistakes made, misselling of a feature or just general queries by customers. We also have to continue ensuring Shariah requirements are being met, as well as balancing the business requirements (which is generally profit driven).

Life is not easy here, despite appearances. It takes a lot of grit to survive as a developer, and you do need a certain amount toughness to handle the day to day tasks. But the rewards are great as it builds you into a competent and wholesome expert in the field after a few years. Patience is also needed and so is hard work.

To all the graduating students out there, do your best in the industry and fight this good fight. There is a bright future out there, as bright as you want it to be.

Presentation on Careers in Islamic Banking

Concept Paper on Liquidity Coverage Ratio

Fresh off the press, the Concept Paper on Liquidity Coverage Ratio is issued by BNM today.

Off-hand, there has been a lot of concerns with the issue of treatment of deposits, especially in the light of the treatment of Mudharaba Deposits as Investment Accounts, and the Wadiah with limitations on Hibah and perhaps the reclassification as Qardh. Each Bank had decided on a course of action with regards to how deposits are being treated and managed. There is expected to be shifts in the deposit structure of each Bank and worries that with the new changes, there will be deposit flight from the Islamic banking financing system.

The Liquidity Coverage Ratio (LCR) Concept PaperLiquidity Coverage Ratio talks about the Bank having enough liquidity to withstand liquidity stress scenarios by maintaining sufficient High Quality Liquid Asset (HQLA).

The LCR is part of BNM’s effort to meet Basel III initiative to ensure high quality capital and liquidity strength of Banks. This is part of the framework that includes Net Stable Funding Ratio (NSFR) and Liquidity Risk Management Standards.

 

The areas covered under the CP includes:

  1. Application of the LCR by Banks
  2. Implementation timeline and transition requirements
  3. Definition of eligible stock of HQLA
  4. Treatment of cash-flow items for LCR computation.

Bankers will really need to digest this document to fully appreciate  the intention of the paper. We have until end of November to come back with feedback on the issues on implementation of the LCR.

The effective date of this CP is 1 June 2015.

Goods and Services Tax on Islamic Products

Goods Services Tax (GST)  will be one of the hot topics for the years to come in Malaysia, when the GST finally comes into place in 2015 to replace the Services Tax. Many arguments have been made on both side of the political divide but the reality is that GST will be implemented and have a huge impact on how services and goods are being priced.

A quick look at the GST finds that Sharia compliant banking, while having all its contracts requiring underlying transactions, asset ownership and movement of actual goods, the impact that the GST may have on Islamic contract will remain similar to what impacts a conventional banking product. There is not expected to have a “worse-off” effect on Sharia compliant banking.

GST

It is heartening to see that Customs has made an effort to understand the various Islamic banking contracts and how it works, and identify potential transactional points where a GST may be imposed. I find the attached document (GST Industry Guide – Islamic Banking (As at 1 November 2013)) extremely useful summary of the intended GST implementation on Sharia banking contracts.

10 particular contracts have been identified and the GST points are outlined accordingly.

Please Click Here

New Reference Rate Framework (Concept Paper)

To read the New Reference Rate Framework Concept Paper, click here

One of the papers currently being floated around for discussion is the new Reference Rate paper. While no date is indicated for the paper to be effective, [Update : today it was announced that effective date by 2 January 2015] its implication will be significant to both the banking system in Malaysia, Islamic and non-Islamic. The main purpose of the paper is the way Banks price their financing product must now be different. Gone will be the Base Lending Rates (BLR) and Base Financing Rates (BFR), and welcome the new defined term; Prime Financing Rate (PFR).

The intention is this; a lot of the things that go into the BLR/BFR are pricing related to risks, and these premiums are loaded into the base borne by customers. This leaves the margin (or customer spread) that is charged becomes somewhat “clean” as a return to the bank, with the exception of impairments (loan/financing defaults). In addition, banks earn “additional” returns from the “savings” built into the BLR/BFR itself. As a lot of risk premiums are built into the base rate, if these risks do not materialise, the bank technically “earns” this savings. You charge the customer in the base rate some premium for the expected risks, but you get the benefit for it. Ideal scenario.

It is therefore no surprise that some good banks, that are able to manage their risks effectively, are pricing their financing at a base-minus rate. It is now common to see home financing packages being priced at BFR minus 2.0% p.a., and the BFR being 6.60% p.a., the pricing is therefore 4.40% p.a. In theory, taking into account the actual cost of funds, adding only the “necessary” premium to cater for risks that is beyond the bank’s control, the base-minus rate still makes decent money for the Banks.

Therefore, even at 4.40% p.a., there is still room for the Bank to earn a margin, after deducting actual cost of funds. I believe the new Reference Rate framework aims to address this issue somewhat.

The concept paper was issued in January 2014 and this will change the way we price the financing portfolio. Under the concept paper, the base pricing shall only consist of the following:

  1. Cost of Funds (COF) – this is essentially the equivalent to interbank borrowing rate or cost of capital
  2. Statutory Reserve Requirement (SRR) – this is a regulatory reserve requirement for financial prudence

As you can see, these components of the new Prime Financing Rate (PFR) leaves very little room for Banks to manoeuvre the rates. COF is market driven, based on interbank lending rates, while SRR is a regulatory requirement based on specific percentage. BNM know that these are the most rigid components to pricing, therefore this may be a deliberate composition selection by BNM aimed at institutions to re-think the pricing formula.

And under the new regime of PFR, the following should no longer be built into the base rate. These costs, if the Banks want it, should be a part of the margin to the Banks loaded into the customers.

  1. Operating Costs
  2. Administrative Costs
  3. Credit Risk Premium
  4. Liquidity Risk Premium
  5. Any profit margin

Prime Financing Rate

These cost, if to be taken by the Bank, must therefore be part of the margin charged onto the customer. Customer will now know what components go into their financing i.e. The margin is now reflective of the risk the Bank perceive onto the customer. The higher the customer’s risk profile, the higher the margin can be.

As such, the 2.50% p.a. maximum margin chargeable onto the base rate should no longer be applicable. As at January 2014, the BLR / BFR is 6.60% and at a margin of +2.50%, the maximum rate chargeable is 9.10% p.a. Under the new regime, the dynamics may now be different for example the PFR could be 3.90% and the margin +5.00% which adds up to 8.90%. In absolute terms it’s cheaper but the customer might balk at the +5.00% margin when they are used to +1.00% or even -1.00% margins.

This is actually a good framework as Banks will have to be more competitive in pricing as the lower the margin, the more risks you are taking on your customers as the risk pricing is built into the margin. Additionally, the concept paper restricts the bank from quoting a price lower than the PFR, and this will make sense because it won’t eat into the Bank’s Cost of Funds. While you can have a BFR-2.00% (i.e. 4.60%), a PFR-2.00% won’t make sense as the PFR component, for example priced at 3.90% will give a net financing rate of 1.90%, and eats into the cost of funds.

In short, the pricing for financing moving forward will be based on the creditworthiness of the customer. Any changes in pricing will be reflecting the changes in operating costs, portfolio defaults or funding strategies. It gives the Bank more flexibility to determine pricing based on agreed scenarios or specific events.

This is a positive development. Banks now have the ability to decide on how to price a product based on real strategies and existing capabilities. Customers will have more transparencies in terms of what they are being charged. This will also spur competition among Banks, and provide better products and services to consumers, especially if the Bank gets its risk profiling right and able to effectively manage its default. All this will require a critical re-think on how a product profitability is determined, and a re-think of how the right management can provide a sustainable financing portfolio.

Note: On the Deposit Rates requirements, there are not much in the Concept Paper itself. Most of the requirements on Deposits are captured under the various EDs such as Wadiah, Hibah, Wakalah and the Investment Account Concept Paper. The only notable mention on the Deposit Rates section is that for Basic Savings Account, returns should be paid irrespective of the account balance and shall not be lower than 0.25% per annum. Also, there is a clause that mentions for Islamic Current Accounts, any hibah/dividend payments should not exceed 2.00% per annum. This, in my opinion, runs counter to the ED on Wadiah (which allows the Bank pure discretionary payment of Hibah, and therefore should not be governed by a capped rate) and the Investment Account Concept Paper (which states that the Bank must reward the customer dividends due to them, based on actual portfolio performances, therefore should not be limited to only 2.00% per annum). These point are against the spirit of Wadiah and Mudharabah, as well as against the Competition Act. We understand BNM is discussing this point internally after receiving industry feedback, and may consider removing this from the framework. We wait with bated breath for this framework to be properly issued.

UPDATE : The 2.0% per annum maximum cap on the Islamic Current Account has been removed via BNM circular dated 20 March 2014. Indeed this puts us back on the right playing field with conventional banking.

For some news on the above topic, please find the following newspaper articles:

 

Pro-Active Compliance of Regulatory Guidelines

There are days I wish I was a multi-millionaire with vast resources, cool regulatory connections, tech-savvy and excellent people motivator. Someone who sees the new regulations for the opportunity it is and the potential in it.

If I was, I’d quit my cosy banking job and set-up my own company that provide services to all Malaysian Banks to support the compliance of the new guidelines. Instead of all the banks scrambling to meet the requirements, they can just outsource all their problems to my set-up to run it. One stop solution to all your headaches.

Perhaps I am writing this out of frustration because I do not have the resources for it. Or perhaps I am writing this for my own interest, hoping someone like Bruce Wayne takes up the challenge and make all our jobs easier. Maybe some of us can get an offer to join this company. That’s wishful thinking I bet.

What would this company / set-up offer to banks? Hmmm where do we start.

Balancing Act

Compliance with the Investment Account Guidelines.

All Banks do not generally set up their operations to work like fund houses where you have fund managers running their investment desks. Neither are there an infrastructure to manage and monitor the fund or portfolio performance, nor having mechanisms to create mark-to-market valuations of the portfolio. Reading the Investment Account guidelines makes one think that the banking model itself has to change to a pure Mudharaba trading house. A dedicated fund house with ready systems supporting the investment requirements and offering their services to Islamic Banks will ease the burden at Banks to develop their own infrastructure.

Tawarruq Guidelines.

This can be a huge component of businesses in the near future. As BNM place more and more emphasis on the big 3 of Musyaraka, Mudharaba and Murabaha, more and more focus will be placed on building the long term infrastructure to support this. Warehousing infrastructure, including managing physical assets and commodities belonging to the Banks, will support the Murabaha envisioned by BNM. A re-vamp of the credit policies and a different approach to risks assessment will support Musyaraka. Mudharaba will encourage the Bank’s “entrepreneurial appetite”  as Banks take a more hands-on approach to investments. Ensuring a compliant structure and supporting the requirements of Sharia on sequencing, documentation, management of commodities, ownership transfers, usufruct and beneficial ownerships and valuation must be developed for the long run. A company which offers these services, or provides an IT platform for this, are something that can reduce the stress placed on the industry.

Special Purpose Vehicles (SPVs).

There a easy lot of opportunities for SPVs to flourish in the Islamic banking market. To support the ownership issues, an SPV can be a useful conduit for the movement of assets which will then create the underlying transactions. Huge deals are done on SPVs. Complicated structures need them. This is a viable legal solution for across border deals. The only question is; what do we do with the SPVs once the transaction is done? Rent it out to another entity, I presume. Either way, SPVs are created for win-win situations for everybody.

The IFSA 2013 is like a large pool of compliance that needed development. There are many opportunities out there and with the coming of even more complicated regulations, Banks are always finding ways to meet the requirements set in the regulations. Some will be creative solutions, while others will address the fundamental requirements of the transaction. Whatever they may be, it will only provide possibilities where fortune smiles on the brave. Take that chance. Hopefully, you will succeed to make all our lives easier.