Regulatory impact of Basel III on Islamic institutions

By:Naseeha Mahomed, EY. She is a Manager in Financial Accounting and Advisory Services and is responsible for the Center in Islamic Finance for Africa.cifa@za.ey.com.

Although the structures underlying Islamic finance transactions differ to those for conventional institutions, Basel III makes no clear distinction between Islamic banks and conventional banks. It requires banks to strengthen their capital positions by improving the quality of capital held. This would result in reduced dependency on debt instruments and would provide further insulation in times of financial difficulty. This move is consistent with the business model of Islamic banks. The definition of capital has also been revised under Basel III. Tier 1 capital comprises of common equity, preferred stocks and hybrid securities; Tier 2 capital comprises of subordinated debt and loans; and and Tier 3 has been revoked.

Islamic financial institutions may be better suited to meet the enhanced capital requirements of Basel III, but these banks would also be subject to regulation of the Islamic Financial Services Board, which proposes more stringent criteria in defining capital (or otherlocal regulators, depending on jurisdiction). For Islamic financial institutions, Tier 1 capital would include common equities, as well as other Shari’ah-compliant instruments that have a high degree of loss absorbency. Tier 2 capital would include hybrid instruments that are convertible into equities in addition to general provisions and reserves held for future losses. Islamic banks obtain deposits primarily through a profit sharing investment account (PSIA) that, whether restricted or unrestricted, is not guaranteed by the Islamic bank. The PSIA is merely used as a mechanism for liquidity risk management, hence excluded from regulatory capital. Reserves such as a profit equalization reserve (PER) and an investment risk reserve (IRR)9 would not form part of an Islamic institution’s capital as defined. The IRR and a component of the PER are also excluded, as they comprise equity of the investment holders and not that of the Islamic institution.

Basel III also requires banks to hold more liquid, low-yielding assets to meet short-term funding needs, but this may have an adverse
impact on profitability. Islamic banks may also face challenges in managing liquidity, as there are constraints on borrowing that may limit access to liquid funding. In addition, surplus liquidity cannot be transferred to conventional banks. There is also a need to further develop Shari’ah-compliant liquid instruments, as many of the instruments currently available are not accessible to Islamic institutions due to the interest prohibition.

In comparison with conventional banks, Islamic banks seem to be slightly less impacted by Basel III, as the business model of an Islamic bank is more conservative. These institutions are better capitalized compared with their conventional counterparts; however, challenges do remain, as existing risk management and corporate governance practices may need to be improved. Uniform application across different jurisdictions is also key in ensuring stability within the overall financial system. Islamic banks should ensure that they are actively engaging with Basel III to position themselves strategically in a competitive market.