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Islamic finance

The important role of sukuk in the Basel III era

By Dr. Sutan Emir Hidayat, Director of the MBA Program, University College of Bahrain

The implementation of Basel III rules has created several challenges to Islamic financial institutions (IFIs) especially with regards to capital adequacy and liquidity requirements. Basel III primarily requires all banks, including Islamic banks, to strengthen their capital and liquidity positions by holding higher quality capital, which would enable banks to absorb financial shocks, and maintain higher level of liquidity, which enables banks to reduce their dependency on money market instruments.

Basel III requires all banks to maintain the minimum ratio of 4.5% for tier 1 common equity capital, an increase from 2% required by Basel II. Basel III also changed the minimum requirement for additional tier 1 capital and tier 2 capital to 1.5% and 2%, respectively, from 2% and 4% previously required by Basel II. In addition, Basel III requires banks to maintain 2.5% capital preservation buffer and 0-2.5% countercyclical capital buffer.

In addition, Basel III also redefines the meaning of capital. According to Basel III, the components of tier 1 capital consist of common equity as core capital, and preferred stock and hybrid securities as additional capital. Subordinated bonds and loans are counted as tier 2 capital.

Given the uniqueness of Islamic banks’ products and operations, the implementation of Basel III rules for Islamic banks and other IFIs requires more clarification. The Islamic Financial Services Board (IFSB) released IFSB-15 in December 2013 with the purpose of introducing a framework for capital adequacy and liquidity requirements to suit the uniqueness of IFIs.

IFSB-15 equity standards and sukuk

The IFSB-15 is an amended and improved version of two previous IFSB standards on capital adequacy, namely IFSB-2 and IFSB-7. IFSB-2 focused on capital adequacy standards for IFIs while IFSB-7 focused on capital adequacy requirements for sukūk, securitizations and real estate investments. IFSB-15 also provides guidelines for the components of regulatory capital (tier 1 and tier 2). Like Basel III, IFSB-15 also defines common equity as the tier 1 core capital and preferred stock as the additional tier 1 capital. However, it is important to note that preferred stock is only considered a Shariah-compliant instrument in some jurisdictions such as Malaysia.

In addition, perpetual musharakah sukuk is also counted as additional tier 1 capital, while mudharabah and wakalah sukuk with maturity of five years or more are counted by IFSB-15 as components of IFIs’ tier 2 capital. However, in practice, other types of sukuk may also be classified as either additional tier 1 or the component of tier 2 capital as long as the sukuk fulfill IFSB-15 requirements for each category of capital. In summary, the IFSB-15 has stressed the important role of sukuk in the Basel III era.

Basel III-compliant sukuk

From the above explanation, it is clear that the implementation of Basel III and IFSB-15 has opened the way for sukuk to be used by Islamic banks and other IFIs as the alternative instrument to comply with regulatory requirements. Certainly, the adoption of Basel III will boost the number of sukuk issuance and their transactions value.

Basel III has already created a new trend in the sukuk market with the birth of so-called “Basel III-compliant sukuk”. There have been nine issuances of such instruments since Basel III’s initial implementation which kicked off in January 2013 with total deals worth more than USD 4.93 billion, according to Annuar (2014).

The first issuance of Basel III-compliant sukuk came from Abu Dhabi Islamic Bank (ADIB) in November 2012, even before the initial implementation of the accord. ADIB issued perpetual mudharabah sukuk with the purpose of raising its additional tier 1 capital. Following ADIB’s success, Dubai Islamic Bank (DIB) issued the second Basel III-compliant sukuk in March 2013 for the same purpose. At the end of 2013 and at the beginning of 2014, three issuances of such sukuk occurred in Saudi Arabia, from Saudi Hollandi Bank (SHB), Saudi British Bank (SAAB) and National Commercial Bank (NCB). Unlike the Emirati banks, the Saudi banks issued the sukuk to increase their tier 2 capitals.

The successful experience in the GCC has been followed by Islamic banks in Southeast Asia especially in Malaysia with the issuances of Basel III-compliant sukuk by AmIslamic Bank, Maybank Islamic, RHB Islamic and Public Islamic (using the murabahah structure) which aim to boost the banks’ tier 2 capital. Many more issuances of such sukuk are expected in the years to come.


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