The Basel III Accord was released in 2010-2011 by the Basel Committee on Banking Supervision (BCBS) following the devastating impact on banks of the 2008 global financial crisis. Basel III is a global regulatory standard on bank capital adequacy, stress testing and liquidity risk that aims to enhance banks’ capability to absorb financial and economic shocks, strengthen risk management and corporate governance practices andimprove transparency and disclosures. It complements forerunners the Basel I and Basel II accords by demanding higher capital requirements on banks especially for Tier 1 capital (Total Common Equity), increasing the capital charge for derivatives and securities transactions (trading book exposures), increasing liquidity coverage ratio and changing the definitions of capital.

As part of the global banking system Islamic banks are also required to comply with the accord especially if their local jurisdiction adopts Basel III rules as part of their regulatory framework. However, Basel III does not differentiate Islamic banks from conventional banks despite their different financial structures. There is hence a need to further interpret and modify the new regulations to fit the specificities of Islamic banks. As they stand, Basel III impacts differently on Islamic banks than conventional banks.

Basel III reforms

Basel III’s reforms can be categorized into micro-prudential and macroprudential measures. Micro-prudential measures address risks at the individual bank level, while macro-prudential measures address risks at the systemic level. On the micro-prudential level, Basel III focuses on amending the requirements for capital and leverage and quantitative liquidity standard. For capital and leverage, Basel III requires more restrictive definitions of capital, higher capital ratios, bigger capital buffers, higher capital charges for counterparty risk and a formal leverage ratio. For the quantitative liquidity standard, liquidity coverage and net stable funding ratios are introduced. The former is used to measure a bank’s short-term liquidity profile (30-day period) which is an indicator of the liquidity buffer held by a bank to cover short-term funding gaps during severe liquidity stress. The latter is used to measure a bank’s medium and long-term liquidity (31-days to 1-year time horizon). On the macro-prudential level, Basel III focuses on how to protect the banking sector from periods of excessive credit growth. In addition, it also promotes the accumulation of capital buffers in good times that can be used in bad times (stress period). The new accord also promotes clear capital conservation requirements to avoid the improper distribution of capital.

Costs to banks

The adoption of Basel III will require banks to increase their equity capital by at least 25%. The extra equity capital obviously comes with higher cost of funds as compared to debt capital. In addition, it also lowers tax advantages and results in the fall of the Return on Equity (ROE). Basel III also requires an additional 40% liquidity buffer and extra 10-15% stable funding over current requirements. The more stringent liquidity requirements may also have a direct impact on banks’ incomes since more investment in liquid assets means lower incomes (low risk low return). The implementation of Basel III will also add compliance costs by 30-50%.

Impact on Islamic banks

CAR and Leverage Ratio: The literature reveals that Islamic banks are in general better capitalized than their conventional counterparts. As a result, higher capital requirements (Capital Adequacy Ratio) as proposed by Basel III will affect conventional banks more than Islamic banks. In addition, Islamic banks are also less exposed to derivative and securitized products (trading book exposures) than conventional banks. As a result, Islamic banks in general need a relatively lower level of risk-weighted assets (RWA) than conventional banks. Due to their higher levels of capitalization, Islamic banks also do not face problems with leverage ratio requirement (set at minimum 3% under Basel III).

Treatment of PSIAs: Due to the nature of sharia-compliant deposits in the form of profit-sharing investment accounts (PSIAs), there is an additional loss buffer for Islamic banks as the underlying mudaraba contract places loss on the investment account holders (rab ul mal) unless the loss is due to the negligence of the bank (mudarib). So, PSIA does not qualify as additional Tier 1 capital according to Basel III. As a result, PSIA and its related assets are excluded from the calculation of CAR.

Liquidity: Basel III requires more stringent liquidity requirements, and this has emerged as a critical challenge for Islamic banks. Liquidity is still a major challenge for Islamic banks worldwide due to a limited number of available sharia-compliant liquidity instruments. In this regard the shortterm sukuk issues from the International Islamic Liquidity Management Corporation (IILM) has helped address the shortage. Overall, however, the current Islamic money market instruments are still relatively less liquid as compared to conventional money market instruments and most Islamic money market securities are either not highly rated or not rated at all. As a result, in certain jurisdictions Islamic banks might be forced to place their funds in conventional money market instruments.

This article has been published in ICD-IDB & Thomson Reuters Islamic Finance Development Report 2014