The tough Basel III regulatory standards, also pose questions for Islamic lenders that could prove expensive:
– Will regulators treat their deposit the same way?
– How will this affect banks with separate Islamic branches.?

Islamic finance frowns on monetary speculation, so their balance sheets are largely clear of the derivatives and complex, risky assets that surfaced in other banks during the global financial crisis. These factors were reported for example last month in http://gulfnews.com/business/banking/islamic-banks-to-benefit-form-basel-iii-capital-rules-1.1373655 However, the issues are wider than the balancde shet.

Interest payments are not allowed by sharia principles, so Islamic banks obtain deposits mostly through profit-sharing investment accounts (PSIAs), which are generally considered to be more volatile than conventional deposits. So Islamic banks are expected to be required to offset that volatility under Basel III by increasing the amount of high-quality liquid assets (HQLAs) that they hold.

This is easier said than done. Islamic securities markets are relatively immature , than conventional markets, so sharia-compliant HQLAs are in short supply –

Islamic commercial banks held about $1.2 trillion worth of assets at the end of last year, according to a study by Thomson Reuters. Those banks account for roughly a quarter of deposits in Gulf Arab countries and over a fifth in Malaysia.

Basel III requires banks to hold enough HQLAs to cover net cash outflows for a 30-day period under a high-stress scenario. Outflows are calculated by applying different weights to funding sources, including PSIAs. The riskier the funding source, the larger the amount of HQLAs needed to cover it.

With the exception of Malaysia and Bahrain, few central banks actively issue instruments which qualify as HQLAs.. Government-issued sukuk qualify, but most sovereign sukuk are either not listed on developed markets or are not actively traded, making those very hard for Islamic banks to obtain. This contrasts with conventional banks’ access to huge markets in high-quality government debt such as U.S. Treasuries and German Bunds. Alternatives such as the short-term sukuk issued by the Malaysia-based International Islamic Liquidity Management Corp, which was established to promote a cross-border market in Islamic instruments, remain small compared with the overall size of the industry..

Much depends on the weightage or “run-off rates” that national regulators who will implement Basel III in their own jurisdictions, choose to assign to PSIAs.

Regulators are keen to develop their Islamic banking sectors, so are unlikely to assign punitive weights. However, they may not be able to treat PSIAs as benignly as conventional bank deposits. For instance, PSIAs held by Islamic banks tend to have relatively short maturities..

The uncertainty looks unlikely to be cleared up at least before next year, when the Malaysia-based Islamic Financial Services Board (IFSB), a global standard-setting body, is expected to release a guidance note on the subject.

The note will deal with issues such as the contractual rights of depositors, for example whether they can withdraw money in fewer than 30 days without a significant penalty, said a source familiar with the IFSB’s deliberations.

Malaysia’s central bank has issued some guidance on PSIAs, saying it will classify them as two types: general PSIAs, broadly equivalent to conventional retail deposits, and specific or restricted PSIAs, deemed similar to managed investment accounts. It has given Islamic banks a two-year transition period to differentiate between those types. Yet while the central bank has already spelled out ratios and weights for Basel III capital adequacy rules, it has not yet announced run-off rates or HQLA requirements for PSIAs.

Basel III says national regulators around the world could assign run-off rates of 3 per cent or higher to stable, conventional bank deposits, and as much as 10 per cent to less stable deposits, according to S&P. Islamic banks may end up being assigned numbers within that range; given the size of the deposits at stake, a variation of several percentage points will make a big difference to how much HQLAs the banks are forced to hold.

The PSIA issue may increase pressure on central banks and governments to address longstanding problems in Islamic finance.

As part of its efforts to develop as an Islamic financial centre, Dubai is actively trying to list sukuk on its exchanges and encouraging its state-linked firms to issue trade-able sukuks, but it may be years before supply begins to meet demand.

Another problem is deposit insurance. 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.

Bahrain introduced Islamic deposit insurance in 1993.

In May this year, Qatar said it would develop an Islamic deposit insurance scheme.

In June, Bangladesh said Islamic deposits would be covered under an existing scheme managed by the central bank.

The first sukuk to have claimed to be in compliance with Basel III requirements was issued in November 2012 by Abu Dhabi Islamic Bank (ADIB). The issuance was worth USD1bln and classified as AT1 capital requirements. This issuance generated an overwhelming response with an order book of USD15.5bln (more than 30 times over-subscribed on the initial benchmark size), and carries
a profit rate of 6.375%, the lowest ever coupon for an instrument of this type. This supports proposition that sukuk issuers have an opportunity to tap into the Basel III-compliant sukuk market.

The Islamic Financial Services Board (IFSB) released draft guidelines on capital adequacy for Islamic banks in November 2012 which clarifies the use of sukuk as additional capital. As per the IFSB Exposure Draft 15, sukuk issued against assets owned by an Islamic bank may be used by that bank as additional capital to meet regulatory minimum requirements. The minimum maturity of the sukuk is five years and it should not have step-up features, such as periodic increases in the rate of return, giving an incentive for the issuer to redeem it.

Over the past two years three UAE based Islamic banks such as Abu Dhabi Islamic Bank, Dubai Islamic Bank and Al Hilal Bank have opted for Tier 1 sukuk issuance totalling $2.5 billion. Issuers of these sukuk say that they qualify as Additional Tier 1 (AT1) capital under Basel III.

The ADIB USD1bln sukuk was based on the contract of Mudharabah and is classified as equity, which therefore does not include principal loss absorption or equity conversion features. Periodic distributions are fully discretionary and non-cumulative. The sukuk is unrated, but will be included in Fitch-eligible capital with a 50% equity credit. It has no maturity date while ADIB can choose to repay the sukuk on certain dates from 2018 if it wishes.

This has significant implications in particular for regional banks that deal with both conventional and Islamic finance. They will have to establish processes to ensure
that the two sets of rules are implemented across two divisions simultaneously. For those banks already specialising in either conventional or Islamic finance,
the impact is no less significant. They will have to comply with new regulatory measures around their liquidity ratios. They will also have to implement strategies for stress testing that allow for complex data to be analysed in order to demonstrate compliance with the Relevant Central Bank’ Basel III directives.

These requirements call for considerable technology change at many banks to ensure that the required financial and risk data can be accurately gathered, cleansed, analysed and reported to board members and the regulator in the
formats required.

Meeting the regulations as they are currently shaped, for Basel III is not a one-time compliance exercise. The requirements will evolve and banks will benefit from taking a long-term view of regulatory compliance. This means developing a framework for implementing consistent compliance practices and implementing a regulatory reporting framework with in-built enterprise-wide risk management tools to ensure ongoing compliance.

Basel III is proceeding globally, with tangible differences evident between jurisdictions such as pace of adoption, the degrees of strict compliance to the Basel Committee guidance, and the resulting technical infrastructure challenges banks face. Some countries in the Middle East have accelerated
capital deduction phase-in periods or changed limited deductions to
full deductions.

Basel III largely focuses on the liability side of the balance sheet, and modifies requirements for both the quantity and the quality of loss-absorbing capital.

There new requirements for a leverage ratio, and for liquidity and stable funding requirements (a short-term 30-day liquidity coverage ratio and a 1-year
net stable funding ratio). Basel III requires more high-quality common equity Tier 1 (CET1) capital relative to total Tier 1 and Tier 2 capital, and adds a number of capital buffers which can only be met with CET1 capital. These buffers are above regulatory minimums that range from an additional 2.5% of risk-weighted assets up to 8.5%, and even higher in some regions. Basel III recommends an additional loss-absorbing buffer for global and domestic systemically important banks, which can range up to 3.5% – and depend on a bank’s cross-jurisdictional activity (only for G-SIBs), size, interconnectedness, substitutability, and complexity.

In the EU the Capital Requirements Directive (CRD IV) which relates to Basel
III creates an additional buffer known as a systemic risk buffer, which is applied to the whole financial sector, and subsets of it, to prevent and to mitigate long-term non-cyclical systemic and macro-prudential risks. EU member states can apply systemic risk buffers of 1% – 3% for all exposures, and up to 5% for domestic exposures, without having to seek prior approval from the European Commission. 6 For banks subject to both a systemically important bank buffer and the
systemic risk buffer, the higher of the two will apply, but if the systemic risk buffer applies to domestic exposures only, they will be combined. Expect similar legislation to follow in this region at some point in the not too distant future.

The Basel III framework includes revisions to risk-weighted assets (RWAs) related to counterparty credit risk, including the treatment of “wrong-way” risk.

Globally,jurisdictions look to be implementing the minimum capital
requirements according to the BCBS schedule (by 2015) or even more
rapidly, with a faster phase-in for some of the largest banks. Many regions will adopt the BCBS phase-in schedule (which begins in 2016), but some Middle Eastern countries may require faster compliance.

The Islamic Financial Services Board’s (IFSB) revised capital requirements for Bassel III could help strengthen the Islamic finance industry, according to a recent Standard & Poor’s Ratings Services report. The report titled ‘Basel III Offers An Opportunity For Islamic Banks To Strengthen Their Capitalization And Liquidity Management,” sets out how Islamic banks will implement Basel III.

A liquidity coverage ratio might address some of the industry’s long-standing weaknesses, particularly the lack of high quality liquid assets (HQLA), said the report. The implementation of Basel III will also test the treatment of profit sharing investment accounts (PSIAs) from liquidity and funding perspective.
PSIA holders are, in theory, obliged to share any losses, but this could increase their volatility and liquidity coverage requirements and reduce their role as stable funding sources, The IFSB is likely to release its guidance note on the parameters and calculation of the liquidity coverage ratio and net stable funding ratio in early 2015.

The $300 million settlement between Standard Chartered (SC) and the New York Department of Financial Services (DFS), announced on 19 August, again highlights operational and regulatory risks for the bank, says Fitch Ratings.
The New York Department of Financial Services (DFS) said the British bank’s internal compliance systems had failed to detect or act on a large number of “potentially high-risk transactions” mostly originating from Hong Kong and the United Arab Emirates. Banking group Standard Chartered is liable to legal action in the UAE after it agreed to close some customers’ UAE accounts in an anti-money laundering settlement with US regulators, the UAE central bank said “because of the material and moral damage which is falling on them”
‘The new punishment came two years after the bank paid US regulators US$667 million to settle charges it violated US sanctions by handling thousands of money transactions involving Iran, Myanmar, Libya and Sudan.

In 2011 Dubai-based Noor Islamic Bank, since re-named Noor Bank, halted a business in which it channelled billions of dollars from Iranian oil sales through its accounts, as Washington stepped up sanctions over Iran’s disputed nuclear plans.

In May last year, the UAE revoked the licences of two local money exchange companies for non-compliance with regulations including rules against money laundering.

Last month The Basel Committee on Banking Supervision last week proposed standards on money laundering risks, which require banks to include AML within their firm-wide risk management process. “Basel’s commitment to AML is fully aligned with its mandate to strengthen the regulation, supervision and practices of banks worldwide, with the purpose of enhancing financial stability,” the committee stated on issuing the proposal for consultation.

AML is a new area for Basel, which usually deals with prudential standards such as the Basel III capital rules. Its efforts are in addition to those of the Financial Action Task Force (FATF), which issued global AML standards in 2012 and a flurry of practice guidelines last week. Basel supports individual country implementation of FATF standards, and views their proposed standards as supplemental to these, including cross-references back to these in its text.

In Iraq last year political and economic Iraqi circles confirmed the presence of extensive money-laundering operations. Weak monitoring systems and political conflicts of interest, were reasons advanced that prevented the exposure of these operations. Ahmad al-Jabouri, a member of the Integrity Committee in the Iraqi parliament, said in a statement that the amount of money subject to laundering operations are around “20% of Iraq’s investment budget.” Iraq’s 2013 general budget is more than $115 billion, $46 billion of which are investment expenditures. According to Jabouri, money-laundering operations make up $9 billion per year