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Basel III, the gift or the curse?

July 26, 2016

 

The 2007-2008 financial meltdown has brought much criticism, anger and a sense of distrust from the public towards financial institutions, especially the banks.  Flames from the meltdown began to simmer during the summer of 2007 when a few investment banks explicitly showed signs 21of strain in the US and in Europe. However, the heat wave of the meltdown was finally felt when Lehman Brothers filed for Bankruptcy back in 2008[1].  Central banks and regulators were under no illusion that the banking sector was erupting into a massive volcano and that some financial institutions were grossly under prepared for such a crisis.

 

Existing regulatory frameworks, mainly Basel II, was deemed weak and lacking resilience with respect to Capital Adequacy, Liquidity Management and Solvency. Following the collapse of Lehman Brothers, banks were reluctant to conduct business with one another. More financial institutions collapsed and the global economy fell into a recession.  Having said that, Islamic banking came out  relatively unscathed with few “burns and cuts” resonating from the global crisis. Economic research was being undertaken with the reference to Islamic banking as the “Viable Alternative”[2]. Much of this was due to the relative simplicity of the Islamic banking products and the avoidance of the US Subprime securities.

 

Nonetheless, a response to remediate the banking system was required not only from central government banks and prudential regulatory bodies but also from the banking supervisory committees. Accordingly, new sets of regulatory requirements were born in the form of Basel III. These new regulations were not only applicable to conventional banking but also to the Islamic banking sector[3]. The notion, “gift or the curse” is particularly interesting in this case for deliberating if Basel III presents benefits disguised as regulatory requirements to Islamic banks. Or whether it causes issues that could further move Islamic banks away from their core Sharia principles.

To shorten this article, I will assume that you all know the formation of Basel. If you want to brush up on your banking supervision (and as super intelligent readers why would you) then please feel free to research this on Google or Wikipedia.

 

Basel II vs Basel III

For the purpose of simplicity, a comparison between Basel II vs Basel III’s core capital requirements can be seen below.

 

Figure1

 

As indicated above, Basel II and Basel III require the same minimum Core Tier 1 requirement of 8%. However, whilst Basel II requires 4% each in the form Core Tier 1 of Common stock. Basel III increases the requirements to 4.5% for Common Stock as part of its Core Tier 1 ratio. A further 2.5% of capital will be required to be held by banks from 2019 bringing the total common stock held to 7%. Industry experts see that the increase in Core Tier 1 within Basel III opens an avenue for Islamic banks to exploit (to structure new instruments). Which would serve the sector not only to fund liquidity but also to serve as regulatory capital.

 

The loss absorption of capital during the downturn is segregated, Tier 1 (including additional tier1 or AT1) is the first set of capital that is to be used by the bank during “going concern” for any loss absorption.  Once Tier 1 capital is used up to absorb losses, only then can Tier 2 capital be used for loss absorption. The idea of Basel III is to improve the quality of loss absorbing capital through increasing the availability of the capital base of the most liquid assets, which are retained earnings and common stocks.

Basel III Impact?

 

As a result, conventional banks will be impacted heavily by these regulations due to their prop trading activities and due to being heavy on debt products as this will attract higher RWAs (Risk Weighted Assets) thus will require higher capital to be set aside.

Islamic banks are less affected by Basel III particularly from a Capital Adequacy perspective. This is due to their simple business model and heavy equity base. The core activities of Islamic banks explain the high level of capital adequacy ratio held even under the Basel III conditions. Islamic Banks conform to Islamic Finance which is underpinned by Sharia law.  Therefore, the majority of their activities revolve around profit and loss sharing (partnerships or deferred sale contracts) and thus this constitutes their capital structure to be primarily equity based as opposed to their conventional counterparts who are heavily debt based. See Figure 2 for the disposition of the Core Tier 1 and Tier 2 Capital for Islamic Banks in the GCC.

 

Figure2

Data Source, World Islamic Banking Competitiveness Report, 2013 – 2014 , EY

 

 

You will be forgiven to think that Islamic Banks have it all good if Basel III itself is somehow giving an “unfair” regulatory advantage to Islamic Banks than their conventional counterparts. The short-term answer is “NO”, the medium-term answer is “MAYBE” and the long-term answer is “LIKELY”. But will Islamic Banks get their act together collectively and globally and have a go at capitalizing on what seems to be a regulatory arbitrage? By offering a more competitive and ethical product to the masses? After all Islamic Banking is not just for Muslims………….

We will delve into Sukuks in Basel III and High Quality Liquid Assets in Part 2 insha’Allah.

 

(The views and opinions expressed in this article are those of the authors and not necessarily reflect the official policy or position of any financial institution the author has worked within, or the opinion of Mashruu)

 

Notes

[1] In March 2007 two Bear Stearns hedge funds nearly lost all of their value and in 15th Sept 2008 Lehman’s file for Bankruptcy (Case Study:  The Collapse of Lehman Brothers Investopedia.Com).  Similarly, in August 2008 BNP Paribas blocks withdrawals from three hedge funds citing complete evaporation of liquidity (Larry Elliott, The Guardian, “Three Myths that sustain the economic Crisis”)

[2] “Viable Alternative” a study conducted by the International Journal of Business and Social Sciences, December 2010.

[3] Conventional Banking = Banking that do not adhere to Islamic Sharia. Islamic banks’ Basel III compliance is dependent on the interpretation of the local regulator with the guidance of the IFSB.

 

 

 

 

 

 

 

 

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