Islamic Banking and Basel II: Challenges and Opportunities Dr.

Nabil Hashad
Introduction
Before the year 1999, Basel Committee for Banking Supervision exerted great efforts for issuing Basel II Accord relating to Banks capital adequacy standard in a way that reflects the changes in the structure and practice of financial markets and banks. Before issuing Basel II Accord, the Committee discussed the causes of banking crisis in many countries. It discovered that the most significant causes that lead to those crisis is that the banks did not manage the banking risks facing them, in addition to the weakness of external and internal supervision (national supervisory authorities). Thus, the new Accord focuses on handling these problems for ensuring banks strength. During the period between the year 1999, and June 2004, the Committee made several amendments on the first edition issued in the year 1999, until the final edition, which was issued in June 2004. The new Accord (Basel II) focused on strengthening regulatory or legal capital framework through minimum capital requirements in a way that it can be more sensitive to the risks facing the banks. At the same time, these requirements provide incentives to the banks, which manage their risks appropriately. Basel II Accord is considered more complex than Basel I Accord for several reasons. One of which is that the assessment of risks in a developed environment that witnesses an increase in the new financial tools and their strategies, seems to be a complex matter. Another reason is that the development and amendment efforts resulted from Basel II Accord have many objectives, a summary of which is described below: (1) Developing ways of measuring and managing banking risks. (2) Achieving consistency between the required amount of capital and the amount of risks that the bank faces.
*

Director of Arab Center for Financial and Banking Studies and Consulting.

(3) Developing discussions between banks officials and national supervisory authorities concerning measuring and managing risks and the relationship between the amount of capital and the amount of risks. (4) Increasing transparency for risks facing the banks, and the sufficient information should be available for banks stakeholders in a timely manner as they share the risks facing the banks. Basel II requirements are considered the most important challenges that face banks generally and banks in the developing countries specifically, as many banks in the developing countries do not have effective risk management systems in place. In addition, market discipline, which means disclosure and which represents the third pillar of the Accord is, not fully applied. Basel II implementation represents the most important challenges for conventional banks; it also represents the most important challenges for Islamic banks, because they have their own characteristics that distinguish them from conventional banks. Thus, not all what was mentioned in Basel II Accord, which is issued by Basel Committee for Banking Supervision, is applicable in Islamic banks. Therefore, to be able to implement Basel II, Islamic banks should take from Basel II what is consistent with the nature of their work, and if there is something inconsistent, then they should comply with what was issued by IFSB concerning capital adequacy.

Regulating Islamic Banking

Islamic finance is developing at a remarkable pace. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to over 300 today in more than 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia the biggest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15 percent a year (although cross-border data remain scarce).1 Islamic financial products are aimed at investors who want to comply with the Islamic laws (Sharia) that govern a Muslim's daily life. These laws forbid giving or receiving interest (because earning profit from an exchange of money for money is considered immoral); mandate that all financial transactions be based on real economic activity; and prohibit investment in sectors such as tobacco, alcohol, gambling, and armaments. Islamic financial
1

El Qorchi, M., Islamic Finance Gears Up, Finance and Development,. IMF. Volume 42, No. 4 December 2005.

institutions are providing an increasingly broad range of many financial services, such as fund mobilization, asset allocation, payment and exchange settlement services, and risk transformation and mitigation. But these specialized financial intermediaries perform transactions using financial instruments compliant with Sharia principles. The growth opportunity as well as the challenges facing the development of the Islamic financial industry in the global market have raised public policy issues in the jurisdictions in which they operate and internationally. These have led international organizations, international standard setters, national regulatory authorities, policy makers and academia to examine various aspects of Islamic financial intermediation each from their own perspective. Focus has been directed notably on Islamic financial institutions (IFIs) risk management practices, the broad institutional environment in which they operate, and the regulatory framework that governs them. A number of institutions have been established to become focal points on major issues, in particular the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI), the International Islamic Rating Agency (IIRA), the Islamic Financial Services Board (IFSB) and the Liquidity Management Center (LMC). 2 Equally important for the operation of Islamic as well as conventional banks is the presence of a conducive institutional environment and an efficient regulatory framework. Such poor supporting institutional infrastructure exposes Islamic banks to systemic risks related to institutional, legal and regulatory issues. At the forefront of these is institutional risk resulting from the lack of consensus among Fiqh scholars on contractual rules governing financial transactions. For instance, while some Fiqh scholars consider the terms of a murabaha or istisna contract to be binding to the buyer, others argue that the buyer has the option to rescind from the contract even after making an order and paying the commitment fee.50 This raises Islamic banks exposure to counter-party risks arising from the unsettled nature of contracts, and may lead to potential litigation problems. A related issue is the general confusion created by the heterogeneous interpretations of the fundamental Shariah rules resulting in differences in financial reporting, auditing and accounting treatments by Islamic banks. It is often argued that Islamic banks are less vulnerable to insolvency as they can share their profits and losses with the depositors and investors according to their joint contracts. This is sometimes raised as an argument for lower capital adequacy ratio for Islamic banks. However, the counter argument is that Islamic banks are subject to greater fiduciary and operational risks and therefore must provide adequate capital to reflect these.

El Hawary, Dahlia; et al. Regulating Islamic Financial Institutions: The Nature of the regulated, World Bank policy research working paper 3227. March 2004.

These special characteristics and risk features of Islamic banking have been recognized by a number of Central Banks. Consequently, they are already developing ways to supervise and regulate these risks. They are also aware of the need for international collaboration and are joining hands in developing standards that can form the basis of a strong infrastructure for Islamic banking. On the question of adaptation of existing international norms and practices for Islamic banks, I note there are many areas where Islamic banks are similar to conventional banks. It is perhaps most practical, cost effective and efficient to adapt relevant standards to Islamic banking. The Basel Committee on Banking Supervision has issued standards and principles in risk areas including credit, liquidity operations, consolidation, capital adequacy etc. Many of these standards are equally relevant and applicable to Islamic banks.

Capital Adequacy and Islamic Banks3

Under capital adequacy one initiative has been to develop a conceptual framework which is appropriate for the risks of Islamic banks but also parallels in important respects that of the 1988 Basel Capital Accord and Basel II. Capital adequacy regulations for non-Islamic banks are based on the assessment of credit and market risk in relation to the capital, which consists of shareholders' equity and other items such as retained earnings, certain categories of reserves, and hybrid instruments combining debt and equity, and which serves as a buffer against losses under both risk headings. As mentioned above, Islamic precepts by contrast involve risk sharing between the banks and holders of their liabilities, a close link between banking transactions and real assets, and avoidance of speculative activities, all of which are capable of affecting the level of banking risks incurred and their incidence between different parties. The bank is also exposed to the risk of losses due to mismanagement and negligence (fiduciary risks), which may lead to legal liability, and to the risk of transfers from shareholders' funds for the purpose of the "smoothing" of investors' returns mentioned above (displaced commercial risk). A major result of this initiative is the 1999 Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).8 This document proposes a method of calculating a capital adequacy ratio (CAR) for Islamic banks. The numerator of the ratio consists of items classified as capital under the 1988 Basel Capital Accord and Basel II with the exception of instruments included which have debt as well as equity characteristics (and

Cornford, Andrew, Capital of Alternative Financial institutions and Basel II, presented at a workshop on "Will Ethical Finance Survive Basel II?, Third International Meeting: Ethics, Finance &Responsibility,October 1-2, 2004, Chteau de Bossey - Geneva

not including PSIA accounts themselves which are not considered to serve the buffer function of capital). The denominator consists of risk-weighted assets as follows: assets financed by the bank's own capital and non-PSIA liabilities plus 50 per cent of assets financed by PSIA (to cover the fiduciary and displaced commercial risks of such assets). Other approaches to the capital requirements and risk management of Islamic banks that put less emphasis than the AAOIFI initiative on features of an Islamic analogue to the 1988 Basel Capital Accord and Basel II have also been proposed by regulators, credit rating agencies, and other commentators. One approach would be to treat Islamic banks for regulatory purposes as mutual funds, whose obligation is to repay not the original sum invested but that remaining after taking account of gains or losses at the time of redemption. However, some commentators have observed that this would fall foul of account holders' own perceptions as to their deposits and investments. Mutual funds complying with Islamic precepts are already available to Muslims and are the recipients of substantial sums. But there are also large sums held in PSIA, which suggest that people distinguish between the two categories of account. However, some commentators would accept regulatory treatment similar to that of mutual funds under the segmentation proposal of the second approach (see below) for entities within Islamic banks whose operations are similar to that of such funds. A second approach would be to structure liabilities and assets in entities designed to satisfy the differing objectives and risk appetites of account holders. In the entity intended for account holders with high risk aversion and a high requirement for liquidity their funds would be backed by asset-backed securities with low risk and easy marketability (i.e. in an entity similar to the "narrow bank" of the theory of conventional banking); and funds of other account holders willing to incur greater risks would be similarly placed in entities with assets chosen appropriately in the light of their investment objectives. Thus ext to the entities for the most risk-averse would be entities similar to mutual funds for investors with risk appetites similar to those of investors in conventional versions of such funds. Regulation of these entities would follow lines similar to that of its conventional counterpart. A third kind of entity would be directed at the requirements of investors willing to take longer-term, riskier positions similar to investments in private equity and venture capital, which would require another type of regulation. This approach would appear to have the advantage over the first approach of accommodating all the different items amongst an Islamic bank's liabilities including non-interest-bearing deposits.

A third approach, which has some support amongst regulators in the United Kingdom, would involve a structuring of liabilities according to a system of subordination of the rights of different categories of account holder. This would be accompanied on the asset side by an appropriate classification of risks and eventual rules on capital adequacy, which take into account the actual risk experience of banks following Islamic precepts.

Capital adequacy and risk management considerations for Islamic financial institutions4
In view of the unique risks faced by Islamic financial institutions, the applicability of Basel standards, which are designed primarily for conventional financial institutions, may not be all that appropriate. In the past, the supervisory authorities of Islamic financial institutions have generally applied the Basel standards. Supervisory authorities may independently vary these standards to capture the unique risks faced by Islamic financial institutions in their own jurisdiction. As a result, there is often no consistency in capital adequacy and risk management standards across Islamic financial institutions in various jurisdictions. With the tremendous growth and increasing internationalization of the Islamic financial system, the supervisory authorities in countries that have an active Islamic financial system realize that there is a need for more consistency in standards. With this in mind, these supervisory authorities established the Islamic Financial Services Board (IFSB). The IFSB acts as an international standard setting body of the regulatory and supervisory agencies that have a vested interest in ensuring the soundness and stability of the Islamic financial services industry. The establishment of the IFSB was the culmination of an extensive two-year consultative process initiated by a group of governors and senior officials of central banks and monetary authorities of various countries, together with the support from the Islamic Development Bank, the International Monetary Fund as well as the Accounting and Auditing Organization for Islamic Financial Institutions. The IFSB has begun the development of two specific prudential standards for Islamic financial institutions, namely, the Capital Adequacy Standards and the Risk Management Standards. These two standards are expected to be issued by early 2005. The main objective of the Capital Adequacy Standards is to address the specific structure and contents of the Shariah compliant products and services offered by Islamic financial institutions not specifically addressed by the Basel Committee. In particular, this includes Islamic financial instruments that are asset-based such as Murabaha and Ijara. Such instruments are exposed to

KPMG, Basel Briefing 8, October 2004.

price risk in respect of the non-financial asset as well as credit risk in respect of the amount due from the counterparty. For profit-sharing instruments, i.e. Musharaka and Mudaraba, the exposure is like an equity position not held for trading, and as such is similar to an equity position in the banking book. Hence it is dealt with under credit risk capital requirements, except in the case of investments (normally short-term) in assets for trading purposes, which are dealt with under market risk capital requirements. Likewise, the Risk Management Standards are developed as a supplement to the risk management standards already established by the Basel Committee. Their purpose is to address the unique risks that Islamic financial institutions face (as discussed above). IFSB issued several important documents with regard to the main issues relating to amending Basel II in a way that it can be consistent with the nature of Islamic banks functions, these documents are as follows: 1Capital adequacy standard for institutions (other than insurance institutions) offering only Islamic financial services. Guiding principles of Risk management for institutions (other than insurance institutions) offering only Islamic financial services. Guiding principles of corporate governance for institutions (other than insurance institutions) offering only Islamic financial services.

2-

3-

We will discuss later a summary of the first and second documents because they represent the key requirements mentioned in Basel II Accord. First: a summary of the first document, which discusses capital adequacy standard. On March 15th, 2005, IFSB issued its exposure draft no. 2, The document is mainly directed to the IIFS (institutions other than insurance institutions offering only Islamic financial services) with the purpose of (1) addressing the specific structure and contents of the Shariah compliant products and services offered by the IIFS that are not specifically addressed by the currently adopted and proposed international capital adequacy standards, and Shariah compliant mitigation; and (2)standardizing the approach in identifying and measuring risks in Shariah compliant products and services and in assigning risk weights (RW) thereto, thus, creating a level playing field amongst the IIFS, in adopting and developing risk identification and measurement practices that meet internationally acceptable prudential standards.

The (IFSB) held its 7th meeting on December 21st, at the Islamic Development Bank in Jeddah, Saudi Arabia, which was attended by 12 Governors of central banks and monetary agencies, the President of the Islamic Development Bank and representatives of 3 central banks. The meeting set the aforementioned draft as the adopted final framework recommended to be fully implemented by the end of 2007. The document covered the calculation of the overall minimum capital requirements for credit, market and operational risks for IIFS and constructed a Capital Adequacy Ratio (CAR) formula. In the stated CAR formula, the calculation of minimum capital adequacy requirements is based on the definition of (eligible) regulatory capital and risk-weighted assets (RWA) in conjunction with Operational Risk for Shariah compliant instruments. It also specified the adjustments to the capital adequacy denominator. Some IIFS may use different product names or contract titles as part of their market differentiation or a commercial expression. While it is not the intention of the IFSB to require IIFS to change the way they manage the business and risks, IIFS are required to use the substance of the Shariah rules and principles governing the contracts of these instruments to form the basis for an appropriate treatment in deriving their minimum capital adequacy requirements. The minimum capital adequacy requirements for IIFS shall be a CAR of not lower than 8% for total capital. The Shariah rules and principles whereby Investment Account Holders (IAS) provide funds to the IIFS on the basis of profit-sharing and loss-bearing Mudarabah contracts instead of debt-based deposits, i.e. lending money to the IIFS, would mean that the IAH would share in the profits of a successful operation, but could also lose all or part of their investments. The liability of the IAH is exclusively limited to the provided capital and the potential loss of the IIFS is restricted solely to the value or opportunity cost of its work (as in getting no remuneration). However, if negligence, mismanagement or fraud can be proven, the IIFS will be financially liable for the capital of the IAH. Therefore, credit and market risks of the investment made by the IAH shall normally be borne by themselves, while the operational risk is borne solely by the IIFS. CREDIT RISK Credit risk exposures in Islamic financing arise in connection with accounts receivable in Murabahah contracts, counterparty risk in Salam contracts, accounts receivable and counterparty risk in Istisnaa contracts, and lease payments receivable in Ijarah

contracts. In this standard, credit risk is measured according to the Standardized Approach of Basel II, except for certain exposures arising from investments by means of Musharakah or Mudarabah contracts in assets that are not held for trading. The latter are to be treated as giving rise to credit risk (in the form of capital impairment risk), and riskweighted using the methods proposed in Basel II either for equity exposures in the banking book or, at the supervisors discretion, the supervisory slotting criteria for specialized financing: Categories RW Strong 90% Good 110% Satisfactory 135% Weak 270%

The assignment of RW shall take into consideration the followings: (1) The credit risk rating of a debtor, counterparty or other obligor, or a security, based on external credit assessments. The IIFS are to refer to their supervisory authorities for eligible external credit assessment institutions (ECAI) that are to be used in assigning credit ratings. (2) Credit risk mitigation techniques adopted by the IIFS; (3) Types of the underlying assets that are sold and collateralized or leased by the IIFS; (4) Amount of specific provisions made for the overdue portion of accounts receivable or lease payments receivable. Supervisory authorities have the discretion to reduce the RW for exposures to the sovereigns and central banks that are denominated and funded in domestic currency. Multilateral Development Banks and other entities may be assigned a 0% RW as determined by the supervisory authorities. Exposures in Investments Made Under Profit Sharing Modes An IIFS may hold investments made under profit-sharing and loss-bearing mode (Mudarabah) and profit and loss sharing mode (Musharakah) that are made not for trading or liquidity purposes but for the purpose of earning investment returns from medium to longterm financing. Such investments are exposed to credit risk in the form of capital impairment risk. Credit Risk Mitigation The exposure in respect of a debtor, counterparty or other obligor can be further adjusted or reduced by taking into account the credit risk mitigation (CRM) techniques

employed by the IIFS. In Islamic banking CRM techniques depend totally on collateralization. Types of collateral commonly employed by the IIFS are as follows: (a) Hamish Jiddiyyah (HJ) (security deposit held as collateral), a refundable security deposit taken by the IIFS prior to establishing a contract, carries a limited recourse to the extent of damages incurred by the IIFS when the purchase order fails to honor a binding agreement to purchase or to lease (b) Urbun (earnest money held as collateral) The urbun taken from a purchaser or lessee when a contract is established can be retained by the IIFS if the purchaser or lessee fails to perform its contractual obligations. (c) Guarantee from a Third Party (d) Pledge of assets as collateral (e) Profit sharing investment account or cash on deposit4 with the IIFS which is incurring the exposure (f) Sukuk that are issued by a sovereign entity, an IIFS, or a conventional bank given high credit rating; also unrated Sukuk listed on recognized exchange with supervisory approval. Any portion of the exposure, which is not collateralized, shall be assigned the RW of the counterparty. Placement of funds made under a Mudarabah contract may be subject to a guarantee from a third party. Such a guarantee relates only to the Mudarabah capital, not to the return. In such cases, the capital should be treated as subject to credit risk with a riskweighting equal to that of the guarantor provided that the RW of that guarantor is lower than the RW of the Mudarib as counterparty. Otherwise, the RW of the Mudarib shall apply. In Mudarabah investment in project finance, collateralization of the progress payments made by the ultimate customers can be used to mitigate the exposures of unsatisfactory performance by the Mudarib. MARKET RISK Market risk is defined as the risk of losses in on- and off-balance sheet positions arising from movements in market prices. The risks in IIFS that are subject to the market risk capital requirement are (1) equity position risk in the trading book, and market risk on trading positions in Sukuk; (2) foreign exchange risk; and (3) commodities/inventory risk.

(i) Equity Position Risk and Trading Positions in Sukuk: The capital charge for equities held for trading or available for sale comprises two charges that are separately calculated for the following types of risk: (a) Specific Risk The capital charge for specific risk is 8% on the summation of all long equity positions and of all short equity positions and must be calculated on a market by market basis (for each national market). The capital charge can be reduced to 4% for a portfolio that is both liquid and well diversified, subject to criteria determined by the supervisory authorities. (b) General Market Risk The capital charge for general market risk is 8% on the difference between the summation of the long position and short position, i.e. the overall net position. These positions must be calculated on a market-by-market basis. (c) In the case of Sukuk held for trading, the provision for specific risk charge will depend on the RW of the issuer and the term to maturity of the Sukuk. (ii) Foreign Exchange Risk The capital charge to cover the risk of holding or taking long positions in foreign currencies, and gold and silver, is calculated in two steps by: (a) Measuring the exposure in a single currency position; and (b) Measuring the risks inherent in an IIFSs portfolio mix of long and short positions in different currencies. (iii) Commodities and Inventory Risk A commodity is defined as a physical product which is and can be traded on a secondary market, e.g. agricultural products, minerals (including oil) and precious metals (excluding gold & silver as they are included in the foreign currency risk section). Inventory risk is defined as arising from holding items in inventory either for resale under a Murabahah contract, or with a view to leasing under an Ijarah contract. The net positions in each commodity will then be converted at current spot rates into the reporting currency and will be given the suitable capital charges. OPERATIONAL RISK

Operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events, which includes but is not limited to, legal risk and Shariah compliance risk. This definition excludes strategic and reputational risks. As the Lines Of Business into which IIFS are organized are different, it is proposed that, at the present stage, the Basic Indicator Approach be used by IIFS, which requires the setting aside of a fixed percentage of average annual gross income over the previous three years. Subject to supervisory authority defining the applicable business lines, the supervisory authority may allow IIFS in its jurisdiction to apply the Standardized Approach in which the percentage (12%, 15% or 18%) of gross income is to be set aside according to the business lines. Capital Charge The extent of losses arising from non-compliance with Shariah rules and principles cannot be ascertained owing to lack of data. Therefore, the IIFS is not required to set aside any additional amount over and above the 15% of average annual gross income over the preceding three years for operational risk. Gross income is defined as sum of net cash inflows less Investment Account Holders share of income PSIAs Defined as the pool of investment funds placed with an IIFS on the basis of Mudarabah. In Wakalah contracts, however, the relationship between IIFS and the investors is a simple agency relationship with the IIFS earning a flat fee rather than a share of profit. The IIFS has full discretionary power in making investment decisions for PSIAU, but in the case of the PSIAR the placement of funds by IIFS is subject to investment criteria specified by the IIFS in the Mudarabah contract or agreed between the IAH and the IIFS at the time of contracting. The IIFS assumes the role of economic agent or Mudarib in placing such funds in income-producing assets or economic activities, and as such is entitled to a share (the Mudarib share) in the profits (but not losses) earned on funds managed by it on behalf of the IAH, according to a pre-agreed ratio specified in the Mudarabah contract. (i) Adjustment to the Capital Ratio Denominator The capital amount of PSIA is not guaranteed by the IIFS and any losses arising from investments or assets financed by PSIA are to be borne by the IAH except under certain circumstances previously described. In principle, therefore, the commercial risks on assets

financed by PSIA do not represent risks for the IIFSs own capital and thus would not entail a regulatory capital requirement for the IIFS. This implies that assets funded by either unrestricted or restricted PSIA would be excluded from the calculation of the denominator of the capital adequacy ratio. In practice, however, the IIFS may forgo its rights to some or all of its Mudarib share of profits in order to offer its IAH a more competitive rate of return on their funds, or may be treated as constructively obliged to do so by the supervisory authority as a measure of investor protection and in order to mitigate potential systemic risk resulting from massive withdrawals of funds by dissatisfied IAH. (ii) Impact on Capital The IIFS is liable for losses arising from its negligence, misconduct or breach of its investment mandate and the risk of losses arising from such events is characterized as a fiduciary risk. The capital requirement for this fiduciary risk is dealt with under operational risk (iii) Displaced Commercial Risk The term displaced commercial risk refers to the risk arising from assets managed on behalf of IAH which is effectively transferred to the IIFSs own capital because the IIFS follows the practice of foregoing part or all of its Mudarib share of profit on such funds, when it considers this necessary as a result of commercial pressure in order to increase the return that would otherwise be payable to the IAH. This practice may also be required by the supervisory authority as mentioned above. While in principle the IIFS has full discretion as to whether it performs this displacement of commercial risk, in practice it may find itself virtually obliged to do so (as a result of commercial and/or supervisory pressure), and this has implications for its capital adequacy which needs to be considered by its supervisory authority. It should be noted that displaced commercial risk does not relate to cover an overall loss attributable to IAH by reallocating profit from shareholders, as Shariah rules and principles do not permit this. (iv) Supervisory Discretion In jurisdictions where an IIFS has practiced the type of income smoothing for IAH that gives rise to displaced commercial risk and has incurred a constructive or implied obligation to continue to do so in the future, the supervisory authority should require regulatory capital to cater for displaced commercial risk. A supervisory authority may also consider that IIFS in its jurisdiction are virtually obliged for competitive reasons to practice the displacement of commercial risk. Also,

supervisory authority may be concerned that the triggering of withdrawals of PSIA funds in the absence of income smoothing for IAH could give rise to systemic risk. In such an environment, the supervisory authority has discretion to require the IIFS, to which the circumstances mentioned apply, to include a specified percentage of assets financed by PSIA in the denominator of the CAR. (Represented by in the Supervisory Discretion Formula illustrated later in this paper) (v) Reserves The IIFS can take precautionary steps by setting up prudential reserve accounts to minimize the adverse impact of income smoothing for PSIA on its shareholders returns and to meet potential but unexpected losses (UL) that would be borne by the IAH on investments financed by PSIA, namely: (a) Profit equalization reserve (PER) comprises amounts appropriated out of the gross income from the Mudarabah to be available for smoothing returns paid to the investment account holders and the shareholders, and consists of a PSIA portion and a shareholders portion; and/or (b) Investment risk reserve (IRR) comprises amounts appropriated out of the income of investment account holders after deduction of the Mudarib share of income, to meet any future losses on the investments financed by the PSIA. Second: the second pillar of Basel II concentrates on the comprehensive assessment of banking risks facing banks; the economic capital is specified in the framework of the comprehensive assessment of risks. Although the risk facing Islamic Banks does not differ much from the risk facing conventional banks, there are some differences because the nature of the functions of Islamic Banks is different. Document no.2 [guiding principles of Risk Management institutions (other than insurance institutions) offering only Islamic financial services] referred to the risks facing Islamic banks and means of their management, and which is described as follows: This document provides a set of guidelines for establishing and implementing effective risk management practices in IIFS. It is intended to serve the fully-fledged banking institutions offering Islamic financial services. These IIFS include, but are not limited to, commercial banks, investment banks, finance houses and other fund mobilizing institutions, as determined by the respective supervisory authorities, that offer services in accordance with Shari`ah rules and principles. This document has been endorsed by the Shari`ah Advisory Committee of the Islamic Development Bank and co-opted Shari`ah scholars representing

central banks and monetary agencies, which are members of the Islamic Financial Services Board (IFSB) on 27 February 2005. This document sets out fifteen principles of risk management that give practical effect to managing the risks underlying the business objectives that IIFS may adopt. The text provides some examples of current practices, recognizing that these practices may change as markets change and as technology, financial engineering and improved coordination between regulatory authorities makes other strategies available. However, the document does not detail every possible control procedure. The IFSB will keep these matters under review. The principles contained in this document are designed to complement the current risk management principles issued by the BCBS and other international standard-setting bodies. Supervisory authority shall decide on which the IIFS will adopt the Guiding Principles set out in this document. In cases where the existing applicable international principles are hari`ahcompliant, these principles are retained and/or expanded. In this regard, this document treats such principles as general principles, and they are summarized under operational considerations in each section. In such cases where these principles are not Shari`ahcompliant, this document states an alternative Shari`ah-compliant approach. This document provides specific guidance for each category of risk, drawn from discussion on industry practices. It outlines a set of principles applicable to the following six categories of risk: Credit risk Equity investment risk Market risk Liquidity risk Rate of return risk Operational risk The IFSB recognizes that the specific risk management practices of each IIFS will vary in scope and content depending on its activities. In certain countries, IIFS are already exploring advanced risk management practices. Nevertheless, all IIFS are expected to make meaningful risk assessments based on the principles described in this document. All

supervisory authorities are encouraged to review their current recommendations, if any, in the light of the principles set forth in this document. However, it is crucial for the IIFS to recognize and evaluate the overlapping nature and transformation of risks that exist between and among the categories of the abovementioned risks. In addition, the IIFS may face consequential business risks relating to developments in the external marketplace. Adverse changes in IIFSs markets, counterparties, or products as well as changes in the economic and political environments in which the IIFS operate and the effects of different Shari`ah rulings are examples of business risk. These changes may affect the IIFSs business plans, supporting systems and financial position. In this regard, the IIFS are expected to view the management of these risks from a holistic perspective. The IIFS are also exposed to reputational risk arising from failures in governance, business strategy and process. Negative publicity about the IIFSs business practices, particularly relating to non-Shari`ah compliance in their products and services, could have an impact upon their market position, profitability and liquidity. Reflecting the different nature of the business and the extent of risks faced by the IIFS, supervisory authorities are urged to adopt a risk-based approach when assessing and evaluating IIFSs risk management activities. The IFSB will issue a separate document in respect of key principles of supervisory review of IIFSs risks, including reputational risk. General Requirement Principle 1.0: IIFS shall have in place a comprehensive risk management and reporting process, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks and, where appropriate, to hold adequate capital against these risks. The process shall take into account appropriate steps to comply with Shari`ah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority. Board of directors (BOD) and senior management oversight As with any financial institution, the risk management activities of IIFS require active oversight by the BOD and senior management. The BOD shall approve the risk management objectives, strategies, policies and procedures that are consistent with the IIFSs financial condition, risk profile and risk tolerance. Such approvals shall be communicated to all levels in the IIFS involved in the implementation of risk management policies. The BOD shall ensure the existence of an effective risk management structure for conducting the IIFSs activities, including adequate systems for measuring, monitoring, reporting and controlling risk exposures. The BOD shall have in place an appropriate body,

independent of the BOD (for example, a Shari`ah board), to oversee that the IIFSs products and activities comply with Shari`ah rules and principles. The BOD shall approve limits on aggregate financing and investment exposures to avoid concentration of risk and, where required, ensure that the IIFS hold adequate capital against these exposures. The BOD shall review the effectiveness of the risk management activities periodically and make appropriate changes as and when necessary. Senior management shall execute the strategic direction set by the BOD on an ongoing basis and set clear lines of authority and responsibility for managing, monitoring and reporting risks. The senior management shall ensure that the financing and investment activities are within the approved limits and must report any exceptions to the BOD. Senior management shall ensure that the risk management function is independent from the risk-taking activities and is reporting directly to the BOD or senior management outside the risk-taking unit. Depending on the scope, size and complexity of the IIFSs business activities, the risk management function is carried out by personnel from an independent risk management unit or from a part of the IIFSs general operations or compliance unit. Small IIFS without a separate risk management function shall develop other checks and balances to make use of limited staff. This personnel shall define the policies, establishes procedures, monitors compliance with the established limits and reports to top management on risk matters accordingly. Risk management process IIFS shall have a sound process for executing all elements of risk management, including risk identification, measurement, mitigation, monitoring, reporting and control. This process requires the implementation of appropriate policies, limits; procedures and effective management information systems (MIS) for internal risk reporting and decision making that are commensurate with the scope, complexity and nature of the IIFSs activities. IIFS shall ensure an adequate system of controls with appropriate checks and balances are in place. The controls shall (a) comply with the Shari`ah rules and principles, (b) comply with applicable regulatory and internal policies and procedures; and (c) take into account the integrity of risk management processes. IIFS shall ensure the quality and timeliness of risk reporting available to regulatory authorities. In addition to a formal standardized reporting system, IIFS shall be prepared to provide additional and voluntary information needed to identify emerging problems possibly giving rise to systemic risk issues. Where appropriate, the information contained in the report shall remain confidential and shall not be used for public disclosure.

IIFS shall make appropriate and timely disclosure of information to IAH so that the investors are able to assess the potential risks and rewards of their investments and to protect their own interests in their decision making process. Applicable international financial reporting and auditing standards shall be used for this purpose.

Basel II: challenges, opportunities and recommendations for Islamic banks

There is no doubt that Islamic banks implementation for Basel II in a sound, effective and integral manner represents the most important challenges facing Islamic banks. Proper implementation of Basel II in Islamic banks requires achieving capital adequacy, which covers credit risk, market risk and operational risk. Thus, it is expected that this would require banks to increase its capital to cover these risks. I think that in the beginning of Basel II implementation in Islamic banks, it would be difficult for Islamic banks to implement advanced approaches either for credit risk or market risk and operational risk. So, I recommend that Islamic banks implement simplified approaches namely, standardized approach for market risk and basic indicator approach for operational risk. Most Islamic banks are the same as most banks in Islamic and Arab countries do not have integral system for risk management (definition and determination of risk measurements, monitoring, supervising, organization, etc.) Consequently, the inadequate and insufficient management for banking risks is not consistent with Basel II requirements, and so, the Islamic banks should establish systems for risk management and train their staff on them. The implementation of Basel II in Islamic banks is considered the most important challenge facing them because this implementation requires complete restructuring for the bank weather for organizational structure or for asset restructure, and that is for the purpose of being consistent Basel II. Although the implementation of Basel II in Islamic banks is the most important challenges they face, but it represents opportunities for Islamic banks where the sound implementation of Basel II will make Islamic banks more efficient and sound and it will enable them to be more capable of competing and occupying bigger share in the financial markets.

References: 1. Cornford, Andrew, Capital of Alternative Financial institutions and Basel II, presented at a workshop on "Will Ethical Finance Survive Basel II?, Third International Meeting: Ethics, Finance &Responsibility,October 1-2, 2004, Chteau de Bossey - Geneva 2. El Hawary, Dahlia; et al. Regulating Islamic Financial Institutions: The Nature of the regulated, World Bank policy research working paper 3227. March 2004. 3. El Qorchi, M., Islamic Finance Gears Up, Finance and Development,. IMF. Volume 42, No. 4 December 2005. 4. KPMG, Basel Briefing 8, October 2004.