SEACEN-IRTIIDB Course On Regulation and Supervision of Islamic Banks Yogyakarta 5june 2006

An overview of the IFSB’s
framework on
(a) Guiding principles of risk management
(b) Capital adequacy standard
for institutions (other than insurance institutions) offering Islamic

financial services (IIFS)
2nd SEACEN-IRTI/IDB COURSE ON

REGULATION AND SUPERVISION OF ISLAMIC BANKS
Yogyakarta, INDONESIA
5 June 2006
ABDULLAH HARON
Project Manager
Islamic Financial Services Board (IFSB)
abdullah@ifsb.org
Islamic Financial Services Board
Agenda
Objectives of the IFSB
An overview of the IFSB’s guiding principles of

risk management and Capital Adequacy Standard
(CAS) for IIFS
Experience in the development of the standard

and expected challenges in its implementation
process
2
Objectives of the IFSB

¾ Article 4 of the Articles of Agreement outlines the objectives of the IFSB,
which include, among others :
To promote the development of a prudent and transparent Islamic

financial services industry by introducing new, or adapting existing,
international standards consistent with Shari’a principles, and
recommend them for adoption.
To provide guidance on the effective supervision and regulation of

institutions offering Islamic financial products and to develop the criteria
for identifying, measuring, managing and disclosing risks, taking into
account international standards for valuation, income & expense
calculation and disclosure.
3
Status of development of the

IFSB standards
Standard on/Guiding Principles Commencement of Issuance of framework
preparation*
Risk Management July 2003 Standard issued in
December 2005
Capital Adequacy July 2003 Standard issued in
December 2005
Corporate Governance May 2004 Exposure Draft (ED)
issued in December
2005
Supervisory Review Process April 2005 Expected ED to be
issued in 2007
Transparency & Market Discipline April 2005 Expected ED to be
issued in 2007
Note : * corresponds to the date of the 1st meeting of the Working Group
4
Guiding Principles of Risk Management

High level overview
5
High level overview of Guiding

Principles of Risk Management
¾Approach
¾Key objective
¾Guiding principles for the management of risk
on specific features of IIFS products and
services, amongst others:
• Equity investment risk
• Rate of return risk
–Displaced commercial risk
• Operational risk
–Sharīàh compliance risk
–Fiduciary risk
6
Approach (1)
¾Rather than prescriptive procedures, the
approach that has been taken by the IFSB is
principle-based approach, applied to
accommodate continuous improvement in the
infrastructures, methodologies and system as
theory and technology permit
7
Approach (2)
¾In identifying the risks to which IIFS are
exposed, as an initial step is to identify inherent
risks which include the following two risks:
• primary risks, i.e. the exposures deliberately entered
into for business reasons when an IIFS decides to
offer a certain type of service; and
• consequential (or operational) risks, i.e. the exposures

that are not actively taken but which are incurred as a
result of business undertaken by the IIFS
8
Key objective of Guiding Principles of

Risk Management (1)
¾The IIFS are expected to view the
management of these risks from a holistic
perspectives
¾The guiding principles define a common

terminology of key risk categories to which IIFS
are exposed, acting as a common language for
further development of regulatory financial
requirements and seen as a stimulant to the
progress of risk management practices
required in Islamic financial services industry:
9

Risk Management (2)
• For example, the rate of return risk (as opposed to
interest rate risk) is essentially the risk with regard to
the result of an investment at the end of the
investment-holding period. We cannot exactly
predetermine such results
• Displaced commercial risk could be the consequence

of the rate of return risk whereby IIFS may be under
market pressure to pay a return that exceeds the rate
that has been earned on assets financed by IAH
10

Risk Management (3)
• At present, in many jurisdictions, the consequence of
the rate of return risk is considered as part of the
strategic risk, hence is left to the individual IIFS to
decide. In some jurisdictions, guidelines on the rate of
return risk including on the use of profit equalisation
reserve (PER) exist.
11
Features addressed by the Guiding

Principles of Risk Management (1)
¾ Inclusion or introduction of principles for equity investment risk and rate of
return risk, along with other risk categories similar to those in Basel
standards such as credit, market and operational risks.
These additional risk categories take into account specific risk profiles of the
profit-sharing and loss-bearing nature of Mushārakah or Muḍārabah
financing.
The context of operational risk category (which comprises documentation,

internal controls and legal risks) has also been extended, to include greater
emphasis on Sharīàh compliance and fiduciary risks whereby IIFS are liable
for negligence and misconduct.
12
Features addressed by the Guiding

Principles of Risk Management (2)
¾ Apart from equity investment and credit risks, market (price) risk and risks
arising from the interaction between assets and sources of funds are
equally important aspects of the risk profile of IIFS as a result of the profit-
sharing nature of investment accounts.
The Guiding Principles stipulate high-level principles, among others, on

some pre-conditions necessary for IIFS when managing the expectations of
IAH. For example, by requiring IIFS to put in place an appropriate framework
for managing displaced commercial risk, where applicable and appropriate
mechanisms to safeguard the interests of all fund providers where funds of
IAH and shareholders are commingled.
13
Fifteen guiding principles of risk

management for IIFS covering:
¾General Requirement for an Effective Risk
Management Processes
¾Credit Risk
¾Equity Investment Risk
¾Market Risk
¾Liquidity Risk
¾Rate of Return Risk
¾Operational Risk
14
Capital Adequacy Standard (CAS)

High level overview
15
High level overview of Capital

Adequacy Standard
¾Approach
¾Key objective
¾Principles for the measurement of capital
adequacy standard on specific features of IIFS
products and services
• Credit (including exposures made under profit sharing
modes that are not made for trading)
• Market
• Operational
• Profit sharing investment account (PSIA)
16
Approach
¾Since the structure and activities of IIFS are
influenced by the Shari`āh rules and principles,
the approach undertaken by the working group
is analysing the intrinsic characteristics of each
contract. For this reason, the CAS is
structured in a matrix format
¾The CAS does not represent an exhaustive list

of products
• Principles for minimum capital adequacy
requirements for credit and market risks arising from a
given type of financial instrument
• Financing and investment instruments
17
Key objective of Capital Adequacy

Standard
¾The standard on Capital Adequacy sets out a
common structure for the assessment of IIFS
capital adequacy requirements, which will
support transparency and consistent
methodology for all IIFS
• This will bring the benefits of a common approach
without compromising Sharīàh rules and principles by
substantially enhancing the transparency of true
obligations within IIFS operations
18
Key objective of Capital Adequacy

Standard (2)
• Recognition of investment account holders (IAH) as
partners in IIFS operations should result in a more
effective use of capital. According to the Quantitative
Impact Study (QIS) conducted by the IFSB last year,
the capital base of IIFS is more than sufficient to meet
their true liabilities, in contrast to critics about them
being undercapitalised
• The standard promotes a level playing field at a global
level as far as common assessment is concerned
especially for the minimum capital requirement in
respect of both credit and market risks arising from
each financing mode at different stages of a contract
19
Principles for the measurement of

capital adequacy requirement (1)
¾IIFS are required to use the substance of the
Sharīàh rules and principles governing the
contracts to form the basis for an appropriate
treatment in deriving their minimum capital
adequacy requirements
¾Capital adequacy requirements vary according

to the transformation of risks at different
contract stages
20
Features addressed by the Capital

Adequacy Standard
¾ Catering for specific structure and contents of Sharīàh compliant
products & services (which are either asset-based, profit-sharing or
sukūk) but not specifically addressed by Basel standards.
• For example, in Murābahah or Ijārah, rather than lending money, an IIFS

has to acquire a physical asset and then sell it back on credit or on lease.
The risk to which the IIFS is exposed transforms from the market risk of
physical assets at the time of acquisition to credit risk at the time of sale
on deferred payment or on lease.
• In measuring the capital adequacy of these contracts, the physical assets

are risk-weighted not only by bucketing them according to different risk
categories but also by differentiating them according to various stages of
contracts.
21
Example of RW at different contract

stage (1)
22
Example of RW at different contract

stage (2)
23

capital adequacy requirement (2)
¾On basis of either Muḍārabah or Wakālah
contract, 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 (unless proven
negligence, mismanagement or fraud)
24
Features addressed by the Capital

Adequacy Standard
¾ Recognition of the profit-sharing investment accounts (PSIA) in the
Capital Adequacy Ratio (CAR) calculation.
As opposed to the emphasis of Basel II Capital Accord on depositors’

protection, the IFSB Standard on Capital Adequacy stresses the
importance of investors’ protection mechanisms (but no guarantee of
capital). As such, assets financed by IAH do not affect risk-bearing capital
of IIFS since they bear their own commercial risk.
25

Credit Risk
26
Comparison on the approach

Criteria Basel II IFSB CAS
Standardised Standardised
Risk weight Calibrated on the basis of Calibrated on the basis of external
external ratings by the BASEL ratings by the BASEL committee.
committee.
Vary according to contract stage
and financing mode.
Treatment of > 150% for venture capital and Simple risk weight method
equity in the private equity investments (RM300% or 400%) or supervisory
banking book slotting method (RW 90%-270%)
Credit Risk Includes financial collateral, Includes hamish jiddiyyah, urbun,
Mitigation credit derivatives, guarantees, PSIA or cash on deposit with IIFS,
Techniques netting (on and off balance guarantees, financial collateral,
sheet). pledge assets
27

capital adequacy for credit risk (1)
¾Credit risk is measured according to the
Standardised Approach of Basel II, except for
certain exposures arising from investments by
means of Mushārakah or Muḍārabah contracts
in assets that are not held for trading
¾Until adequate historical data are available,

the IFSB employs Basel’s risk weights (RW)
28
Measurement of Credit Risk

Individual Claims based Investment Made Under Profit-Sharing and Loss-
on External Assessment bearing Modes
Simple Risk Weight

Standardised Approach Slotting Method
Method
Four Categories
Risk Weight based on External Credit Assessments (R)
CRWA = R x Net Exposure*
*Amount of exposure less eligible collateral (Net exposure)
29

Market Risk
30

Category Equity, FX, Interest rate risk in Equity, FX, benchmark risk in
the trading book, commodity the trading book, commodity,
Inventory
Silver falls under foreign

exchange risk
Measurement 1996 market risk amendments 1996 market risk amendments
(standardised and internal (standardised measurement
model) method)
31

capital adequacy for market risk (1)
¾Apart from market risk exposures arising from
equity, foreign exchange, commodities, the
exposures also include trading positions in
Sukuk and inventory risk, which results from
IIFS holding assets with a view to re-selling or
leasing them
¾In the case of equity investment made by

means of Mushārakah or Muḍārabah contract
where the underlying assets are commodities
held for trading, market risk provisions for
commodities are applicable 32

capital adequacy for market risk (2)
¾For inventory risk, only simplified approach is
applicable
33
Measurement of Market Risk

Equity Position/ Sukuk Foreign Exchange Commodity/Inventory @
Standardised Approach
Maturity
Simplified
Ladder
+ Specific + Single Currency + Directional +

+ General Market + Portfolio + Forward Gap
+ Basis +
@In case of inventory risk, only simplified approach is applicable
Market Risk Capital Requirement (MRCR)
MRWA = 12.5 * MRCR 34

Market risk weight conversion factor

¾ The 12.5 conversion factor is the reciprocal of the minimum CAR
i.e. 8%, and thus converts the market risk capital charges into
equivalents of risk weighted assets as follows:
Hence an asset that attracts a 100% credit risk weight results in a
minimum capital requirement (i.e. a capital charge) of 8
An asset that attracts a market risk capital charge of 8 is
converted to a risk weight of 8*12.5 = 100
When this 100 is added to the credit risk weighted assets, it can
be treated in the same way, resulting in a capital charge of 8
¾ If a supervisor decides to impose a minimum capital

requirement different from (e.g. higher than) 8%, the conversion
factor should be changed accordingly
35

Operational Risk
36

Gross Annual average gross Annual average gross
income income (previous three income (previous three
years) years) excluding PSIA’s
share of income
37

capital adequacy for operational risk
¾Sharīàh compliance risk is a type of
operational risk facing the IIFS which can lead
to non-recognition of income and resultant
losses
¾The extent of losses from non-compliance with

Sharīàh rules and principles cannot be
ascertained owing to lack of data
• Supervisory authorities have discretion to impose a
RW higher than 15% as they deem fit to cater for the
Sharīàh compliance risk of a particular IIFS.
38
Measurement of Operational Risk

Basic Indicator
Approach
Annual Average Gross Income X 15%
(previous three years)
Capital Requirement
Gross income is defined as:
Net income from financing activities (e.g. selling price

less purchase price) which is gross of any
provisions and operating expenses; plus
Net income from investment activities; plus
Fee income (e.g. commission and agency fee)
Less:
Investment account holders’ share of income
Operational Risk Capital Requirement (ORCR)
ORW = 12.5 * ORCR 39


Relating to
Profit Sharing Investment Accounts
40
Capital adequacy requirement relating

to assets financed by PSIA (1)
¾The IIFS assumes the role of economic agent
or Muḍārib in placing such funds in income-
producing assets or economic activities, and as
such is entitled to a share (the Muḍārib 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
Muḍārabah contract
• The commercial risk on assets financed by PSIA do
not represent risks for the IIFS’s own (shareholders’)
capital and thus would not entail a regulatory capital
requirement for the IIFS
41

¾This implies that assets funded by either
unrestricted or restricted PSIA would be
excluded from the calculation of the
denominator of the capital ratio
42

Treatment of equity of investment accounts
¾ Standard formula
100% of credit & market risk of risk-weighted assets financed by IAH is
borne by IAH
100% of operational risk of managing these assets is borne by IIFS
¾ Supervisory discretion formula

Some proportion α (decided by supervisor) of credit & market risk of risk-
weighted assets financed by IAH is deemed to be borne by IIFS (displaced
commercial risk)
100% of operational risk of managing these assets is borne by IIFS
43
Risk-weighted assets that is

subject to CAR in Standard
Formula
RWA of PSIA
(CR + MR)
44
CAR Standard Formula

Standard Formula
ELIGIBLE CAPITAL
Capital amount of
PSIA is not TOTAL: FUNDED BY PSIA:
guaranteed by the RWA (CR + MR) + LESS RWA (CR + MR)
IIFS and any ORW
losses arising
from investments
or assets financed
by PSIA are to be
borne by the IAH, Example:
unless losses are EL = 8, CRWA = 40, MRWA = 40, ORW = 20 and
due to the IIFS’s
negligence, assets funded by PSIA is 70% of total on- and off-
misconduct or balance sheets
breach of
investment
mandate. 8 / [100 – 56] = 8 / 44 = 18.2%
45

¾In practice, the IIFS (a) may forgo its rights to
some or all of its Muḍārib share of profits in
order to offer its IAH a more competitive rate of
return on their funds, or (b) 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
46
Risk-weighted assets that is

subject to CAR in Supervisory
Discretion Formula
RWA funded by restricted PSIA (CR+MR)
α RWA funded
by unrestricted RWA funded
PSIA (CR+MR)- by
RWA funded by
(1- α) RWA funded by PSIA
Total(CR+MR)
RWA
excl PER and non-PSIA
RWAunrestricted PSIA
funded by unrestricted PSIA IRR
(CR+MR) (CR+MR+OR)
(CR+MR)
α RWA funded by
RWA of PER and IRR of unrestricted PSIA
PER and IRR of
(CR+MR) unrestricted PSIA
(CR+MR)
47
CAR Supervisory Discretion Formula

Supervisory
Discretion Formula ELIGIBLE CAPITAL
TOTAL RWA (CR+MR+OR)
Applicable in
jurisdiction where
less
supervisory RWA funded by restricted PSIA (CR+MR)
authority less
considers the IIFS (1-α) RWA funded by unrestricted PSIA (CR+MR)
is obligatory to less
smooth income for α RWA funded by PER and IRR (CR+MR)
IAH as part of a
mechanism to
minimise Restricted PSIA Unrestricted All other funds Total
(20%) PSIA (30%)
withdrawal risk
(50%) (100%)
and is concerned
with systemic risk. CRWA 8 20 12 40
MRWA 8 20 12 40
ORWA 0 0 20 20
Total 16 40 44 100
Assume eligible capital = 8, α = 30% and PER and IRR = 10% of unrestricted PSIA
48
CAR Supervisory Discretion Formula Cont’d

ELIGIBLE CAPITAL 8
= 14.60%
TOTAL RWA (CR+MR+OR) 40+40+20
less less
RWA funded by restricted PSIA (CR+MR) (8+8)
less less
(1-α) RWA funded by unrestricted PSIA (CR+MR) (1-30%) (20+20)
less less
α RWA funded by PER and IRR (CR+MR) 30% (2+2)
Restricted PSIA Unrestricted All other funds Total

(20%) PSIA
(50%) (30%)
CRWA 8 20 12 40
MRWA 8 20 12 40
ORWA 0 0 20 20
Total 16 40 44 100
49
Comparison of using different formula
Standard Supervisory Basel

formula discretion formula
formula
Capital adequacy ratio 18.2% 14.6% 8%
50
Challenges in the Implementation
51
Challenges in implementing these

standards (1)
¾ In general, both national authorities and IIFS may face some of the
following challenges in implementing these standards. On the other hand,
the IFSB is not empowered to enforce its proposed standards and
guidelines. Therefore, the IFSB relies solely on the voluntary adoption of
standards by its members and IIFS i.e. the quality of standards is crucial
The obligation on national authorities to ensure that they have sufficient

infrastructures, skills and domestic guidelines in order to effectively
supervise IIFS operations. The prerequisites to implement these standards
imply sound understanding by supervisors and regulators of the risks
involved in Shari’a compliant transactions and how such risks are managed.
Absence of adequate risk-mitigating tools and infrastructure for IIFS or even

risk management culture among IIFS. As such, the whole process of
assessment and measurement of risks will continue to evolve for quite some
time.
52
Challenges in implementing these

standards (2)
Assurance that the implementation of these standards will not put IIFS at a
competitive disadvantage in particular in terms of huge cost implications,
lengthy product development process etc. IIFS should keep in mind that
implementing these standards will help them having a better understanding
of their risk appetite in sourcing their funds and in pricing new businesses in
order to determine risk profiles of their fund providers.
Although enhanced disclosure of information is generally perceived as

beneficial by the public, its benefit to IAH, given their level of understanding
of their rights and obligations, has yet to be proven.
53
Thank you for your attention
54

SEACEN-IRTIIDB Course On Regulation and Supervision of Islamic Banks Yogyakarta 5june 2006

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An overview of the IFSB’s

for institutions (other than insurance institutions) offering Islamic

2nd SEACEN-IRTI/IDB COURSE ON

An overview of the IFSB’s guiding principles of

Experience in the development of the standard

Objectives of the IFSB

 To promote the development of a prudent and transparent Islamic

 To provide guidance on the effective supervision and regulation of

Status of development of the

Guiding Principles of Risk Management

High level overview of Guiding

• consequential (or operational) risks, i.e. the exposures

Key objective of Guiding Principles of

¾The guiding principles define a common

Key objective of Guiding Principles of

• Displaced commercial risk could be the consequence

Key objective of Guiding Principles of

Features addressed by the Guiding

 The context of operational risk category (which comprises documentation,

Features addressed by the Guiding

 The Guiding Principles stipulate high-level principles, among others, on

Fifteen guiding principles of risk

Capital Adequacy Standard (CAS)

High level overview of Capital

¾The CAS does not represent an exhaustive list

Key objective of Capital Adequacy

Key objective of Capital Adequacy

Principles for the measurement of

¾Capital adequacy requirements vary according

Features addressed by the Capital

• For example, in Murābahah or Ijārah, rather than lending money, an IIFS

• In measuring the capital adequacy of these contracts, the physical assets

Example of RW at different contract

Example of RW at different contract

Principles for the measurement of

Features addressed by the Capital

 As opposed to the emphasis of Basel II Capital Accord on depositors’

Capital Adequacy Standard (CAS)

Comparison on the approach

Principles for the measurement of

¾Until adequate historical data are available,

Measurement of Credit Risk

Simple Risk Weight

Risk Weight based on External Credit Assessments (R)

CRWA = R x Net Exposure*

*Amount of exposure less eligible collateral (Net exposure)

Capital Adequacy Standard (CAS)

Comparison on the approach

Criteria Basel II IFSB CAS

Silver falls under foreign

Principles for the measurement of

¾In the case of equity investment made by

Principles for the measurement of

Measurement of Market Risk

+ Specific + Single Currency + Directional +

Market Risk Capital Requirement (MRCR)

MRWA = 12.5 * MRCR 34

Market risk weight conversion factor

¾ If a supervisor decides to impose a minimum capital

Capital Adequacy Standard (CAS)

Comparison on the approach

Criteria Basel II IFSB CAS

Principles for the measurement of

An overview of the IFSB’s guiding principles of

Experience in the development of the standard

To promote the development of a prudent and transparent Islamic

To provide guidance on the effective supervision and regulation of

The context of operational risk category (which comprises documentation,

The Guiding Principles stipulate high-level principles, among others, on

As opposed to the emphasis of Basel II Capital Accord on depositors’

The obligation on national authorities to ensure that they have sufficient

Absence of adequate risk-mitigating tools and infrastructure for IIFS or even

Although enhanced disclosure of information is generally perceived as