Friday, January 20, 2012

Islamic finance complexity (Part IIh)

It has been a while since I added to the Islamic finance complexity series of posts, but I was reading an article that I thought would provide a return to the series (and also back to the liabilities side of Islamic banks' balance sheets).  The IFSB is beginning work on its standards for capital adequacy to incorporate changes in Basel 3, which prompted me to look at one of their Guidance Notes already out there (IFDB-4 [pdf]), which deals with capital requirements around profit-sharing investment accounts (PSIA), which are a large part of Islamic banks' liabilities (equivalent to deposits).

The standard from IFSB provides guidance to regulators to determine the treatment of liabilities (and the assets they finance) for capital adequacy calculations.  What is at issue with the PSIA is whether the assets financed by PSIA should be given a risk-weighting in the capital computation greater than zero (i.e. there should be some capital set aside for the assets they finance).

The theoretical proposition with PSIA is that the assets the bank invests the PSIA funds in should not be treated as assets needing capital set against it.  The logic is that since PSIA investment account holders (IAHs) are liable as rabb ul-mal (in a mudaraba) or muwakkil (in a wakala) to bear any loss and the bank only gets a share of profits (if any) or a fee, respectively, that are generated by the assets.

However, since most Islamic banks--either by choice or because they are required to by their regulators--set up profit-equalization reserves and investment risk reserves, and also can "[forego] all or part of its Mudārib share of profits on investing UIAH [unrestricted IAH] funds, or donating to the UIAH part or all of the profit on investments financed by shareholders’ funds, so as to enhance the profit payout to the UIAH".

As a result, the bank is bearing some displaced commercial risk from the investments financed by IAHs because they will--to some degree--bear the risk of loss in the funds invested that were provided by IAHs.  As a result, while the contracts in their pure form would not expose the bank to possible losses, in actuality the bank has to set aside some capital to pay for these losses.  The IFSB guidance note provides guidance to regulators to determine the calculation of what portion of assets financed by IAH depositors should be considered "at risk" (thus needing a risk weighting based on their own structure).

One of the more interesting discussions in the guidance notes was surrounding the status of IAHs, in terms of how the regulators expect depositors to be treated should the bank become insolvent:
"In practice, there is considerable ambiguity in  the nature and characteristics of UPSIA, which vary among IIFS and jurisdictions. At one extreme, IAH are highly protected so that UPSIA tend to be deposit-like products where the returns are 'stabilised'". 
At the other extreme:
"UIAH have no claim as creditors over the assets of the IIFS (as do conventional depositors). Instead, they have a claim to the assets financed by their funds (including their share of any undistributed profits and less any losses), including their share of assets financed by commingled funds, in respect of  which they rank  pari passu with the shareholders after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors."
One note here is that current account holders are depositors under, for example, qard hasan, who have their principal guaranteed, but are not entitled to profit.  Between the two extremes, there are any number of possibilities where depositors are neither treated like current account holders or fully liable to lose the full value of their principal.  The qualification of UIAH (unrestricted IAH) is done because a restricted IAH would have specific assets financed using their funds and therefore would have their funds at risk of loss based on the performance of the assets they finance. 

The distinction in regulatory treatment of mudaraba and wakala depositors across jurisdictions provides another example of how it is not necessarily as simple as arguing whether Islamic banks' deposits should be fully pass-through (a pure mudaraba) or not.  It also highlights the fact that the regulatory environment facing Islamic banks is not uniform and also not necessarily easily transferable to how Islamic banks work. 

UPDATE: I just saw an article which describes some of the different factors that affect whether PSIAs will impact Islamic banks' capital requirements, from the IFSB seminar in Malaysia. 

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