Research Paper (printed copy)

Instruments for Meeting Capital Adequacy Requirements under Basel III: A Shari'ah Perspective Authors: Dr. Beebee Salma Sairally Dr. Marjan Muhammad Madaa Munjid Mustafa Pages: 45
Weight: 200g
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The Basel III regulatory framework has set out new regulatory capital requirements for banking institutions in order to further strengthen the banking sector’s ability to absorb shocks arising from economic and financial stress. Basel III has increased the minimum capital levels to be maintained by banks and has also redefined the criteria for qualifying regulatory capital instruments. Total regulatory capital under Basel III will be increased to 10.5% by 2019 as compared to the current 8% of risk-weighted assets (RWA). The components of regulatory capital have also been reclassified as Tier 1 and Tier 2, with Tier 3 capital being abolished under Basel III. The redefined criteria for qualifying regulatory capital under Basel III will also impact on the forms of capital instruments that will be suitable to be issued as Tier 1 (T1), Additional Tier-1 (AT1) and Tier 2 (T2) capital.

In particular, it is noted that Basel III has distinguished between going-concern (where the bank is still solvent and continuing operation) and gone-concern (where the bank is facing financial distress) scenarios and has specified the type of capital instruments that will be affected by adverse economic conditions based on the stage at which the crisis occurs. It thus requires the subordination principle to be applied to the capital instruments such that there is a ranking of Common Equity Tier 1 (CET1), AT1 and T2 instruments under Basel III. This provides for T1 capital, which comprises CET1 and AT1, to absorb losses under a going-concern scenario and for T2 instruments to absorb further losses when the bank reaches the point of non-viability or gone-concern.

Besides affecting regulatory capital at the level of conventional banks, the changes resulting from the Basel III regulations have an inevitable impact on the capital-raising exercise of Islamic banking institutions (IBIs). The main concern is whether the Basel III capital instruments can be issued by IBIs without raising SharÊÑah concerns and thus meet the objective of strengthening the resilience of IBIs in the event of economic and financial stress. Specifically, the key SharÊÑah concern related to meeting Basel III requirements is subordination of the capital instruments so that the ranking order of CET1, AT1 and T2 is maintained and, accordingly, ensuring that CET1 and AT1 will bear losses under a going-concern scenario while T2 instruments bear losses only in the event of non-viability or gone-concern.

Subsequent to Basel III regulatory capital requirements, it is noted that regulatory bodies such as Bank Negara Malaysia (BNM) and standard setting bodies such as the Islamic Financial Services Board (IFSB) have issued guidelines for IBIs on the maintenance of regulatory capital in compliance with Basel III regulations. While the IFSB and BNM have provided their outlook on the qualifying SharÊÑah-compliant instruments that IBIs can issue as part of regulatory capital, it is observed that discussions are not yet settled about suitable instruments which will meet both SharÊÑah requirements and the objectives of Basel III.

This research thus compares the qualifying Additional Tier- 1 (AT1) and Tier-2 (T2) capital instruments under Basel III. It also compares the qualifying AT1 and T2 capital instruments as recommended by the regulatory bodies such as BNM and IFSB. In particular, the research examines the SharÊÑah issues, especially related to subordination, arising in both equity-based and exchange-based contracts when used for structuring AT1 and T2 capital instruments. It also discusses the current subordinated ÎukËk issued by IBIs worldwide for meeting regulatory capital requirements. In the light of the discussion, the most appropriate SharÊÑah contracts relevant for structuring AT1 and T2 capital instruments are proposed. The study relies on content analysis of the classical and contemporary literature as well as case studies of regulatory capital instruments issued under Basel II and Basel III in practice.

The study finds that IBIs have been issuing mainly general obligation, subordinated and unsecured ÎukËk, structured using mushÉrakah and muÌÉrabah principles, as T2 instruments under Basel II. These ÎukËk represented general obligation ÎukËk in the sense that they were linked neither to any specific project nor to any underlying asset; nor were specific assets purchased with the ÎukËk proceeds; instead, the ÎukËk proceeds were totally or partially commingled in the general SharÊÑah-compliant financial services business of the obligor or IBI such that the obligor would have a general obligation to pay the ÎukËk holders. The principle of subordination was also applied to these equity-based ÎukËk issued, whereby, in the event of losses there would be an obligation to pay deposit liabilities and other senior creditors first, and the equity-based ÎukËk would be paid thereafter. Moreover, the ÎukËk represented unsecured obligations of the issuer, and no collateral was given to back their repayment.

It was noted that only two subordinated ÎukËk have been issued so far as AT1 capital under Basel III. These were the subordinated, perpetual muÌÉrabah ÎukËk issued by Abu Dhabi Islamic Bank (ADIB) in 2012 as AT1 capital; and the issuance of a USD 1 billion AT1 perpetual ÎukËk by Dubai Islamic Bank (DIB) in March 2013.



Unrestricted equity-based ÎukËk are inherently subordinated by nature to debt obligations and thus are able to absorb losses under both going-concern and gone-concern scenarios. Nonetheless, the paper is of the view that only mushÉrakah ÎukËk (partnership between the issuer and the investors) can be used for structuring equity-based capital instruments for meeting Basel III requirements. Other equity-based structures such as muÌÉrabah and wakÉlah ÎukËk (either restricted or unrestricted) cannot be considered for AT1 and T2 under Basel III because the capital raised thereby is given on the basis of trust (yad al-amÉnah), and thus should be segregated from the IBI’s assets and cannot be calculated as part of its regulatory capital. As a result, the muÌÉrabah and wakÉlah ÎukËk holders should have a first claim on the residual value of the portion of the assets financed by their funds.


Accordingly, this research finds that there are two possible approaches to comply with Basel III and SharÊÑah requirements. First, to avoid the SharÊÑah issues related to the issue of subordination, it recognizes the mushÉrakah contract as the most suitable for structuring perpetual, subordinated, unsecured AT1 capital instruments and for structuring long term, subordinated and unsecured T2 capital instruments. However, from a SharÊÑah perspective, it will not be possible to maintain the ranking order of CET1, AT1 and T2 as per Basel III requirements, unless a legal stratagem such as waÑd bi tanÉzul (promise to relinquish one’s rights) is applied to allow for the issue of subordination. This research instead adopts the view that CET1 and the mushÉrakah-based AT1 and T2 capital instruments will all be ranked pari passu with one another in the event of losses. This approach would still be deemed compliant with the philosophy of Basel III, which in substance aims to strengthen the resilience of the banking sector by increasing the total equity of the Risk Weighted Assets (RWA). With regard to the conversion of AT1 and T2 mushÉrakah ÎukËk into ordinary shares at the point of non-viability, the paper finds that such conversion would be a matter of complying with (conventional) legal requirements to change the status of the mushÉrakah ÎukËk into ordinary shares. Moreover, if the mushÉrakah ÎukËk is structured similar to non-voting shares or Class B shares of conventional finance, no conversion is required as both equity-ÎukËk holders and ordinary shareholders are ranked pari passu in terms of loss. However, ordinary shareholders can agree to give a higher profit rate to the mushÉrakah ÎukËk holders because, from the SharÊÑah perspective, there is no objection to having a profit-sharing ratio that differs from the partners’ capital contributions.

The second approach is to use mushÉrakah ÎukËk for AT1 and convertible murÉbaÍah or ijÉrah ÎukËk for T2 instruments. This will enable exchange-based T2 capital instruments to be ranked above mushÉrakah AT1 capital instruments during the going-concern scenario without raising any SharÊÑah concerns. Furthermore, conversion of the exchange-based T2 instruments would be a possible option to enable them to absorb losses in the event of non-viability. This approach would help in achieving the effect of subordination among CET1, AT1, T2 instruments and current and saving accounts and general creditors during the going-concern and gone-concern scenarios.

It is noted that under either of the two approaches, it is not possible for AT1 capital instruments to be structured using exchange-based contracts as this would not be in line with the Basel III requirements, which require that such instruments be perpetual in nature, and no debt instrument can have such a characteristic.

Instruments for Meeting Capital Adequacy Requirements under Basel III: A Shari'ah Perspective