Capital Adequacy Module

Transcription

1 Capital Adequacy Module

2 Table of Contents CURRENT VERSION DATE CA A: Introduction... 01/05 CA A-1 Application...01/05 CA A-2 Purpose...01/05 CA A-3 Key requirements...01/05 CA A-4 Regulation history...01/05 CA B: General guidance and best practice... 01/05 CA B-1 Introduction...01/05 CA B-2 Guidance provided by other international bodies...01/05 CA B-3 Enforceability...01/05 CA 1: Scope and coverage of capital charges... 01/05 CA 1.1 Introduction...01/05 CA 1.2 Measuring fiduciary and displacement risks...01/05 CA 1.3 Measuring credit risks...01/05 CA 1.4 Measuring market risks...01/05 CA 1.5 Reporting...01/05 CA 1.6 Summary of overall capital adequacy requirements...01/05 CA 2: The capital requirement... 01/05 CA 2.1 Introduction...01/05 CA 2.2 Definition of capital...01/05 CA 2.3 Limits on the use of different forms of capital...01/05 CA 2.4 Calculation of the CAR for Islamic banks...01/05 CA 2.5 Minimum capital ratio requirement...01/05 CA 3: Credit risk... 01/05 CA 3.1 Introduction...01/05 CA 3.2 Risk weighting On-balance-sheet asset category...01/05 CA 3.3 Risk weighting Off-balance-sheet items...01/05 CA 4: Equity risk... 01/05 CA 4.1 Introduction...01/05 CA 4.2 Specific risk calculation...01/05 CA 4.3 General risk calculation...01/05 CA 5: Foreign exchange risk... 01/05 CA 5.1 Introduction...01/05 CA 5.2 De Minimis exemptions...01/05 CA 5.3 Calculation of net open positions...01/05 CA 5.4 Calculation of the capital charge...01/05 CA 6: Commodities risk... 01/05 CA 6.1 Introduction...01/05 CA 6.2 Calculation of commodities positions...01/05 CA 6.3 Maturity Ladder Approach...01/05 CA 6.4 Simplified Approach...01/05 CA 7: Gearing requirements... 01/05 CA 7.1 Gearing...01/05 APPENDICES Appendix CA 1: CA: Capital Adequacy October 2006 Table of Contents: Page 1 of 1 A worked example of the maturity ladder approach for commodities risk calculation

3 CHAPTER CA A: Introduction CA A-1 Application CA A-1.1 Regulations in this module are applicable to locally incorporated banks on both a stand-alone, including their foreign branches, and on a consolidated group basis. CA A-1.2 In addition to licensees mentioned in paragraph CA A-1.1, certain of these regulations (in particular gearing requirements) are also applicable to full commercial branches of foreign banks in the Kingdom. Section: CA A-1: Application January 2005 Page 1 of 1

4 CHAPTER CA A: Introduction CA A-2 Purpose CA A-2.1 The purpose of this module is to set out the Agency s capital adequacy regulations and provide guidance on the risk measurement for the calculation of capital requirements by banks referred to under CA A-1.1. CA A-2.2 The module also sets out the minimum gearing requirements which relevant banks (referred to in section CA A-1) must meet as a condition of their licensing. CA A-2.3 The Agency requires in particular that the relevant banks maintain adequate capital, in accordance with the Regulation in this module, against their risks as capital provides banks with a cushion to absorb losses without endangering customer accounts. Due to this, the Agency also requires the relevant banks to maintain adequate liquidity and identify and control their large credit exposures that might otherwise be a source of loss to a licensee on a scale that might threaten its solvency. CA A-2.4 The regulations contained in this section are consistent in all substantial respects with the approach recommended by the Basel Committee on Banking Supervision and the Statement on the Purpose and Calculation of the Capital Adequacy Ratio for issued by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). CA A-2.5 The Agency recognises that the Basel Committee guidelines may not address specific characteristics of the various products and services offered by Islamic banks. Therefore, the Agency has adopted a risk-based approach and has tailored the regulations to address the specific risk characteristics for Islamic banks. CA A-2.6 This module provides support for certain other parts of the, mainly: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Licensing and Authorisation Requirements; BMA Reporting Requirements; Credit Risk Management; Market Risk Management; Operational Risk Management; Liquidity Risk Management; High Level Controls: Relationship with Audit Firms; Enforcement; and Penalties and Fines. Section: CA A-2: Purpose January 2005 Page 1 of 1

5 CHAPTER CA A: Introduction CA A-3 Key requirements CA A-3.1 All locally incorporated banks are required to measure and apply capital charges in respect of their credit and market risk capital requirements. The capital requirement CA A-3.2 Banks are allowed two classes of capital instruments (see section CA 2.2) to meet their capital requirements for credit risk and market risk, as set out below: Tier 1: Core capital Supports the calculation of credit risk weighted assets and at least 28.57% of market risk. Tier 2: Supplementary capital Supports credit risk and market risk subject to limitations. Measuring credit risks CA A-3.3 In measuring credit risk for the purpose of capital adequacy, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative riskiness. Measuring market risks CA A-3.4 The minimum capital requirement for equities is expressed in terms of two separately calculated charges, one relating to the specific risk of holding a long position in an individual equity, and the other to the general market risk of holding a long position in the market as a whole. Measuring foreign exchange risk CA A-3.5 The measurement of the foreign exchange risk involves, as a first step, the calculation of the net open position in each individual currency including gold and as a second step, the measurement of the risks inherent in the bank s mix of assets and liabilities positions in different currencies. Section: CA A-3: Key requirements January 2005 Page 1 of 3

6 CHAPTER CA A: Introduction Measuring commodities risk CA A-3.6 Banks should adopt either the simplified approach to calculate their commodities risk and the resultant capital charges or the maturity ladder approach. Where banks have Salam and Parallel Salam contracts, the maturity ladder approach must be used. Minimum capital ratio requirement CA A-3.7 On a consolidated basis, the Agency has set a minimum Risk Asset Ratio ("RAR") of 12.0% for all locally incorporated banks. Furthermore, on a solo basis, the parent bank is required to maintain a minimum RAR of 8.0% (i.e. unconsolidated). Maintaining minimum RAR CA A-3.8 All locally incorporated banks must give the Agency, immediate written notification of any actual breach by such banks of either or both of the above RARs. Where such notification is given, the bank must also provide the Agency; no later than one calendar week after the notification, with a written action plan setting out how the bank proposes to restore the relevant RAR(s) and report on a weekly basis thereafter on the bank's relevant RAR(s) until such RAR(s) have reached the required target level(s). CA A-3.9 The Agency considers it a matter of basic prudential practice that, in order to ensure that these RARs are constantly met, banks set up internal "targets" of 12.5% (on a consolidated basis) and 8.5% (on a solo basis) to warn them of a potential fall by the bank below the Agency's required minimum RARs. Where a bank's capital ratio falls below its target ratio, the General Manager should notify the Agency immediately, however, no formal action plan will be necessary. The General Manager should explain what measures are being implemented to ensure that the bank will remain above its minimum RAR(s). CA A-3.10 The bank will be required to submit the PIRI forms to the Agency on a monthly basis, until the RAR(s) exceeds its target ratio(s). Section: CA A-3: Key requirements January 2005 Page 2 of 3

7 CHAPTER CA A: Introduction Gearing requirements CA A-3.11 For Full Commercial Bank and Offshore Banking Unit licensees, deposit liabilities should not exceed 20 times the respective bank s capital and reserves. CA A-3.12 For Investment Bank licensees, deposit liabilities should not exceed 10 times the respective bank s capital and reserves. Section: CA A-3: Key requirements January 2005 Page 3 of 3

8 CHAPTER CA A: Introduction CA A-4 Regulation history CA A-4.1 CA A-4.2 This module was first issued on 1st January 2005 as part of the Islamic principles volume. All regulations in this volume have been effective since this date. All subsequent changes are dated with the month and year at the base of the relevant page and in the Table of Contents. Chapter 3 of Module UG provides further details on maintenance and control. A list of most recent changes made to this module are detailed in the table below: Summary of changes Module Ref. Change Date Description of Changes Evolution of the Module CA A-4.3 Prior to the development of, the Agency had issued various circulars representing regulations relating to capital adequacy requirements. These circulars have now been consolidated into this module covering the capital adequacy regulation. These circulars and their evolution into this module are listed below: Circular Ref. Date of Issue Module Ref. Circular Subject PIRI BC/09/01 26 Nov 2001 CA Prudential Information Returns for Islamic Financial Institutions OG/78/01 20 Feb 2001 CA 2.5 Monitoring of Capital Adequacy BC/01/98 10 Jan 1998 CA 2.5 Risk Asset Ratio Effective date CA A-4.4 The contents in this module are effective from the date depicted in the original circulars (see paragraph CA A-4.3) from which the requirements are compiled. Section: CA A-4: Regulation history January 2005 Page 1 of 1

9 CHAPTER CA B: General guidance and best practice CA B-1 Introduction CA B-1.1 This chapter provides general guidance on Capital adequacy requirements, unless otherwise stated. CA B-1.2 It sets best practice standards and should generally be applied by all licensees to their activities. Section: CA B-1: Introduction January 2005 Page 1 of 1

10 CHAPTER CA B: General guidance and best practice CA B-2 Guidance provided by other international bodies Basel Committee: The management of banks' off-balance-sheet exposures a supervisory perspective CA B-2.1 In March 1986, the Basel Committee on Banking Supervision issued a paper titled The management of banks' off-balance-sheet exposures a supervisory perspective (see CA B-2.2 This paper examines off-balance-sheet risks from three angles market/position risk, credit risk and operational/control risk. Part III of this paper examines credit risk (including control of large exposures, settlement risk and country risk), with particular emphasis given to the assessment of the relative risks of the different types of off-balance-sheet activity. Section: CA B-2: Guidance provided by other international bodies January 2005 Page 1 of 1

11 CHAPTER CA B: General guidance and best practice CA B-3 Enforceability CA B-3.1 These guidance should not be taken as legally binding requirements, unless otherwise embodied in Bahrain law or by regulation. CA B-3.2 It should be noted that the provisions in this chapter are to be taken as guidance, unless otherwise stated, supplementing the Regulations set out in this module. Section: CA B-3: Enforceability January 2005 Page 1 of 1

12 CHAPTER CA 1: Scope and coverage of capital charges CA 1.1 Introduction CA All locally incorporated banks are required to measure and apply capital charges in respect of their fiduciary and displacement risk, credit and market risk capital requirements. CA Fiduciary and displacement risk is defined as [ref AAOIFI]. CA Credit risk is defined as the potential that a bank s counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk exists throughout the activities of a bank in the banking book and in the trading book including both on- and off-balance-sheet exposures. CA Market risk is defined as the risk of losses in on- or off-balance-sheet positions arising from movements in market prices. The risks subject to the capital requirement of this module are: (a) (b) (c) the risks pertaining to equities in the trading book; foreign exchange risk throughout the bank; and commodity risk throughout the bank. Section: CA 1.1: Introduction January 2005 Page 1 of 1

13 CHAPTER CA 1: Scope and coverage of capital charges CA 1.2 Measuring fiduciary and displacement risks CA Islamic banks mobilise funds on a profit and loss sharing basis (PLS). However, certain risks are associated with such PLS accounts. These risks are referred to as fiduciary and displaced commercial risk. CA To cater for these risks the Agency has accepted the recommendations contained in the AAOIFI s statements and requires the inclusion of 50% of the risk weighted assets of the Profit Sharing Investment Accounts (PSIA) in the denominator of the capital adequacy ratio. Section: CA 1.2: Measuring fiduciary and displacement risks January 2005 Page 1 of 1

14 CHAPTER CA 1: Scope and coverage of capital charges CA 1.3 Measuring credit risks CA In measuring credit risk for the purpose of capital adequacy, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative riskiness. CA The Agency has adopted the risk weightings recommended by the Basel Committee on Banking Supervision, where applicable. However, the Basel Committee does not define the risk weightings for some of the specific Islamic contracts. CA In Islamic banking, the legal form is as important as the substance of the transaction otherwise the transaction would not be permissible under Shari a. Therefore, when assigning risk weights to the various Islamic contracts, banks should consider the legal form of the transactions as well as the substance. CA The framework of weights consists of four weights 0%, 20%, 50% and 100% for on- and off-balance-sheet items, which based on a broad-brush judgment, are applied to the different types of assets and off-balance-sheet exposures within the banking book. CA The resultant different weighted assets and off-balance-sheet exposures are then added together to calculate the total credit-riskweighted assets of the bank. CA The Agency has addressed the issue of the risk weightings for some of the commonly used Islamic contracts. If banks are involved in contracts not covered below they should contact the Agency and agree on an appropriate risk-weighting category. Murabaha and Murabaha to the purchase orderer CA The Agency as a policy requires that all Murabaha contracts be based on binding promises. The Murabaha receivables should be assigned a risk weight based on the credit standing of the obligor as recommended by the Basel Committee. Section: CA 1.3: Measuring credit risks January 2005 Page 1 of 5

15 CHAPTER CA 1: Scope and coverage of capital charges Mudaraba contracts CA Mudaraba contracts should be assigned a risk weighting according to the underlying investments. Where Mudaraba funds are invested in securities listed on recognised exchanges and the price volatility is based on market movements, these should be removed from credit risk weightings and subject to market risk regulations. Examples would be equity Mudarabas where banks may have direct exposure in the value of the underlying equities or commodity Mudarabas. CA Investments in other Mudarabas such as real estate or leasing should be assigned risk weightings according to the standing of the underlying investment as per the Basel Capital Accord. CA Where a Mudaraba fund invests in another Mudaraba contract, which in turn makes investments at its own discretion, the risk weight would be based on the credit standing of the counterparty (investee Mudarib) as recommended by the Basel Committee. Investments in particular asset classes made at the discretion of the (investor) Mudaraba fund should be assigned risk weighting according to the underlying investments, where possible. Musharaka contracts CA Musharaka contracts refer to partnerships in specific transactions or projects. These exclude participation in the share capital (equity) of other enterprises. Risk weights should be assigned in accordance with the standings of the underlying investment as per the guidelines of the Basel Committee. Musharaka in real estate, plant and machinery or other similar assets attract a 100% risk weighting. CA Musharakas in trading transactions will attract risk weighting as per the standing of the underlying investment, which in all cases would attract a 100% risk weighting. Where the transaction involves trading in commodities which may be traded in secondary markets, these should be removed from credit risk weighting and subjected to market risk regulations. CA In cases where it is difficult to ascertain the composition of the underlying asset, risk weight would be assigned based on the credit standing of the counterparty. Section: CA 1.3: Measuring credit risks January 2005 Page 2 of 5

16 CHAPTER CA 1: Scope and coverage of capital charges Ijarah / Ijarah Muntahia Bittamleek assets CA Under Shari a, substantial risks and rewards of ownership of assets may not be transferred to lessees. Therefore, assets acquired for the purpose of leasing under Ijarah or Ijarah Muntahia Bittamleek contracts should be carried on the balance sheet of the lessor and assigned a risk weighting of 100%. CA However, where these are residential properties, leased under Ijarah Muntahia Bittamleek with the lessee s option to buy at the end of the lease term and to use the properties for residential purposes, a 50% risk weighting is assigned, where the lessor has a first enforceable charge on the assets. Istisna a and parallel Istisna a contracts CA The accounting for these contracts should be in accordance with Financial Accounting Standard (FAS) No. 10: Istisna a and Parallel Istisna a, issued by AAOIFI. CA Istisna a and parallel Istisna a contracts would attract risk weighting as per the credit standing of the respective counterparties in accordance with the Basel Committee. Salam and parallel Salam CA Amounts paid in respect of Salam contracts (for which there exists a parallel Salam contract) should normally be assigned a risk weight as per the credit standing of the customer in accordance with the Basel Committee. CA Salam and parallel Salam contracts would attract risk weighting as per the credit standing of the respective counterparties in accordance with the Basel Committee. Section: CA 1.3: Measuring credit risks January 2005 Page 3 of 5

17 CHAPTER CA 1: Scope and coverage of capital charges Participations and equity investments CA The supervision of banks for capital adequacy purposes is carried out on a consolidated basis, taking into account all holdings of the capital of other entities by the concerned bank. For subsidiaries, the preferred mode of consolidation is to add the assets and liabilities into the accounts of the parent on a line-by-line basis. For associate companies (i.e. where the parent bank owns 20% or more of the voting stock, and/or has voting control of the concerned company), the assets and liabilities should also be consolidated on a line-by-line basis. If banks do not wish to consolidate subsidiaries or associates (that meet the above criteria), they must contact the Agency to agree on the accounting treatment to be used. Participations and investments which amount to below 20% of the voting capital of the concerned company should be accounted for at fair value and weighted at 100%. CA Banks which have subsidiary and associate companies must also be supervised for capital adequacy on a solo basis (i.e. after deducting all holdings of the share capital of all subsidiaries and associates (that meet the criteria in paragraph CA above) and excluding all their assets and liabilities from the accounts of the parent bank). Holdings of other participations and equity investments need not be deducted on a solo basis, but should be accounted for at fair value and weighted at 100%. Banks should note paragraph CA in respect of the treatment described in this paragraph and in paragraph Intra fund balances CA Transactions between the corporate book (i.e. self-financed and financed by unrestricted investment accounts) and restricted investment accounts are not allowed, unless approved by the Agency on a temporary basis. Section: CA 1.3: Measuring credit risks January 2005 Page 4 of 5

18 CHAPTER CA 1: Scope and coverage of capital charges CA If permitted by the Agency, on a temporary basis, the following weightings will be applied: (a) (b) Corporate or unrestricted investment funds invested in Restricted Investment Accounts. Risk weighting would be assigned on the underlying asset as per the Basel Committee Guidelines and in accordance with the guidance set out under chapters CA 1 to CA 6. Restricted investment account funds invested in corporate books. (i) In the corporate books, the assets financed by restricted investment accounts would be included as part of the corporate assets and risk weighting assigned in accordance with the guidelines. (ii) 0% risk weighting should be assigned to the funds invested by the restricted investment accounts in the corporate books in order to avoid double counting as the resultant assets are already risk weighted in the Bank s books. (iii) Banks must agree with the Agency on the treatment of investments by restricted investment accounts in the corporate book. The Agency will consider each case on its merit. Section: CA 1.3: Measuring credit risks January 2005 Page 5 of 5

19 CHAPTER CA 1: Scope and coverage of capital charges CA 1.4 Measuring market risks Trading book CA The trading book means the bank s positions in financial instruments (including off-balance sheet instruments that are intentionally held for short-term resale and/or which are taken on by the bank with the intention of benefiting in the short-term from actual and/or expected differences between their buying and selling prices, or from other price variations, and positions in financial instruments arising from matched principal brokering and market making). Treatment of risks associated with any option transactions should be agreed in advance with the Agency, who will consider the issue on a case by case basis. CA Each bank should agree to a written policy statement with the Agency as to which activities are normally considered trading and constitute part of the trading book. Trading book s definition should be consistently applied by the bank from year to year. CA It is expected that the trading activities will be managed and monitored by a separate unit and that such activities should be identifiable because of their intent, as defined in paragraph CA above. Equity risk CA The capital charges for equities will apply based on the current market values of items in a bank s trading book. Foreign exchange and commodities risk CA The capital charges for foreign exchange risk and for commodity risk will apply to a bank s total currency and commodity positions, with the exception of structural foreign exchange positions in accordance with section CA 5.3 of these regulations. Section: CA 1.4: Measuring market risks January 2005 Page 1 of 4

20 CHAPTER CA 1: Scope and coverage of capital charges Exemptions CA Banks will be allowed certain de minimis exemptions from the capital requirements for foreign exchange risk, as described in section CA 5.2 of these regulations. For the time being, there shall be no exemptions from the trading requirements, or from the capital requirements for commodity risk. Bank s own fund and Profit and Loss Sharing Investment Accounts (PSIA) CA Banks must compute capital charges for own funds subject to market risk, as well as those of the PSIA. For the purpose of computing the capital adequacy ratio, 50% of the bank s market risk weighted assets relating to the PSIA (restricted and unrestricted) must be included in accordance with AAOIFI s Statement on Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks. Consolidation CA As with the credit risk capital requirements, the market risk capital requirements apply on a worldwide consolidated basis. Only a bank, which is running a global consolidated book, may apply the offsetting rules contained in the remainder of these regulations, on a consolidated basis with the prior written agreement of the Agency. However, where it would not be prudent to offset or net positions within the group, for example where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis, the Agency will require the bank to take individual positions into account without any offsetting. CA Notwithstanding that the market risk capital requirements apply on a worldwide consolidated basis, the Agency also monitors the market risks of banks on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. The Agency is particularly vigilant to ensure that banks do not pass positions on reporting dates in such a way as to escape measurement. Section: CA 1.4: Measuring market risks January 2005 Page 2 of 4

21 CHAPTER CA 1: Scope and coverage of capital charges Approach to measurement CA For the measurement of their market risks, banks will measure the risks in a standardised manner, using the measurement framework described in chapters CA 4 to CA 6. CA The standardised methodology uses a building block in which the capital charge for each risk category is determined separately. For equity positions risk, separate capital charge for specific risk and the general market risk arising from these positions are calculated. The specific market risk is defined as the risk of loss caused by an adverse price movement of a security/ units due principally to factors related to the issuer. The general market risk is defined as the risk of loss arising from adverse changes in aggregate market prices. For commodities and foreign exchange, there is only one general market risk capital requirement. CA All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into. Monitoring CA Formal reporting, to the Agency, of the market risk exposure and capital adequacy shall take place as at the end of each calendar quarter. The returns relating to any quarter should be submitted to the Agency by the 20 th day of the first month of the following quarter. Furthermore, banks are expected to manage their market risk in such a way that the capital requirements for market risk are being met on a continuous basis (i.e. at the close of each business day and not merely at the end of each calendar quarter). Banks are also expected to maintain strict risk management systems to ensure that their intra-day exposures are not excessive. CA Banks daily compliance with the capital requirements for market risk will be verified by the independent risk management department and the internal auditor. It is expected that the external auditors will perform appropriate tests of the bank s daily compliance with the capital requirements for market risk. Where a bank fails to meet the minimum capital requirements for market risk on any business day, the Agency must be informed in writing. The Agency will then seek to ensure that the bank takes immediate measures to rectify the situation. Section: CA 1.4: Measuring market risks January 2005 Page 3 of 4

22 CHAPTER CA 1: Scope and coverage of capital charges CA Besides what is stated in paragraph CA above, the Agency will consider a number of other appropriate and effective measures to ensure that banks do not window dress by showing significantly lower market risk positions on reporting dates. Section: CA 1.4: Measuring market risks January 2005 Page 4 of 4

23 CHAPTER CA 1: Scope and coverage of capital charges CA 1.5 Reporting CA Formal reporting, to the Agency, of capital adequacy shall be made in accordance with the requirements set out under section BR 3.1. Section: CA 1.5: Reporting January 2005 Page 1 of 1

24 CHAPTER CA 1: Scope and coverage of capital charges CA 1.6 Summary of overall capital adequacy requirements CA Each bank is expected to monitor and report the level of risk against which a capital requirement is to be applied, in accordance with section CA 1.4. The bank s overall minimum capital requirement will be: (a) (b) the credit risk requirements laid down in these regulations; PLUS the capital charges for market risks calculated according to the measurement frameworks described in chapters CA 4 to CA 6, summed arithmetically. Section: CA 1.6: Summary of overall capital adequacy requirements January 2005 Page 1 of 1

25 CHAPTER CA 2: The capital requirement CA 2.1 Introduction CA Islamic banks are allowed two types of own funds to meet their capital requirements for credit risk and market risk, as set out below: Tier 1: Tier 2: Supports the calculation of credit risk weighted assets and at least 28.57% of market risk. Supports credit risk and market risk subject to limitations. CA For the purpose of calculating its Capital Adequacy Ratio (CAR), the risk-weighted assets of an Islamic bank consist of the sum of the risk-weighted assets financed by the Islamic bank s own capital and liabilities, plus 50% of the risk-weighted assets financed by the Islamic bank s PSIA. This applies to both unrestricted PSIA that are accounted for on the Islamic bank s balance sheet and restricted PSIA that are accounted for off the balance sheet. Section: CA 2.1: Introduction January 2005 Page 1 of 1

26 CHAPTER CA 2: The capital requirement CA 2.2 Definition of capital Tier capital CA Tier Capital forms the numerator of the Capital Adequacy Ratio. It is defined as the cornerstone of a bank s strength. CA The essential characteristics of capital are that it should: (a) (b) (c) Represent a permanent and unrestricted commitment of funds; Be freely available to absorb losses and thereby enable a bank to keep operating whilst any problems are resolved; Not impose any unavoidable charge on the earnings of the bank. CA For the purpose of defining Tier capital, the Agency has broadly adopted the recommendations contained in AAOIFI s Statement on the Purpose and Calculation of Capital Adequacy for. However, some restrictions have been placed on the inclusion of profit equalisation and investment risk reserve as Tier 2 capital. For components of Tier 1 and Tier 2 capital refer to paragraphs CA to CA Tier 1: Core capital CA Tier 1 capital shall consist of the sum of items (a) to (b) below, less the sum of items (c) to (d) below: (a) Bank s permanent share capital and disclosed reserves in the form of legal, general and other reserves created by appropriations of retained earnings, share premium, capital redemption reserves and other surplus (as shown in its balance sheet), but excluding revaluation reserves and prudential reserves (profit equalisation reserves and investment risk reserve as defined in the AAOIFI s Financial Accounting Standard No: 11 Provisions and Reserves). In case of an Islamic fund having participation and / or B class shares (not carrying voting rights), their treatment as capital or unrestricted investment accounts (for the purpose these regulations) must be agreed with the Agency. The Agency will consider each case on its merit. Section: CA 2.2: Definition of capital January 2005 Page 1 of 3

27 CHAPTER CA 2: The capital requirement (b) Minority interests, arising on consolidation, in the equity of subsidiaries that are less than wholly owned. LESS: (c) (d) Goodwill Current year s cumulative net losses which have been reviewed as per the International Standards on Auditing (ISA) by the external auditors. Tier 2: Supplementary capital CA Tier 2 capital shall consist of the following items: (a) Interim retained profits that have been reviewed as per the ISA by the external auditors. (b) Asset revaluation reserves, which arise in two ways. Firstly, these reserves can arise from the revaluation of fixed assets from time to time in line with the change in market values, and are reflected on the face of the balance sheet as a revaluation reserve. Secondly, hidden values or latent revaluation reserves may be present as a result of long-term holdings of equity securities valued in the balance sheet at the historical cost of acquisition. Both types of revaluation reserve may be included in Tier 2 capital, with the concurrence of the external auditors, provided that the assets are prudently valued, fully reflecting the possibility of price and forced sale. In the case of latent revaluation reserves, a discount of 55% will be applied to the difference between the historical cost book value and the market value to reflect the potential volatility of this form of unrealised capital. (c) General provisions held against the future, presently unidentified, losses are freely available to meet losses that subsequently materialise and therefore, qualify for inclusion within supplementary elements of capital, subject to a maximum of 1.25% of total risk-weighted assets (both credit and market risk weighted). Prescriptions ascribed to impairment of particular assets or known liabilities should be excluded. Section: CA 2.2: Definition of capital January 2005 Page 2 of 3

28 CHAPTER CA 2: The capital requirement (d) (e) Profit equalisation reserve and investment risk reserve as defined in FAS No. 11: Provisions and Reserves, issued by AAOIFI, up to a maximum amount equal to the capital charge pertaining to the 50% the risk weighted assets financed by unrestricted and restricted investment account holders. 45% of unrealised gains on equity securities held as availablefor-sale (on an aggregate net-basis). Deductions from Tier 1 and Tier 2 capital CA For the calculation of capital adequacy on a solo basis, the following item shall be deducted from the sum of Tier 1 and Tier 2 capital (goodwill will have been already deducted from Tier 1 capital): (a) (b) Investments in and financing of a capital nature to unconsolidated subsidiaries and associates. The assets representing the investments in subsidiary companies whose capital is deducted from that of the parent would not be included in total assets for the purpose of computing the capital adequacy ratio. Holdings of own shares and any financing facility provided to the parent company to finance the shares of the subsidiary. Section: CA 2.2: Definition of capital January 2005 Page 3 of 3

29 CHAPTER CA 2: The capital requirement CA 2.3 Limits on the use of different forms of capital CA The following constraints apply to the CAR calculations: Constraint 1: Tier 2 capital allocated to credit risk (see section A20.7 of guidelines in Appendix BR 3) should be less than or equal to 50% of the Tier 1 capital allocated to credit risk (see section A20.6 of guidelines in Appendix BR 3) Constraint 2: Tier 2 capital allocated to market risk (see section A20.13 of guidelines in Appendix BR 3) plus Tier 2 capital allocated to credit risk (see section A20.7 of guidelines in Appendix BR 3) should be less than or equal to Total Tier 1 capital available (see section A20.1 of guidelines in Appendix BR 3) Section: CA 2.3: Limitations on the use of different forms of capital January 2005 Page 1 of 1

30 CHAPTER CA 2: The capital requirement CA 2.4 Calculation of the CAR for Islamic banks CA Firstly, the banks should calculate minimum capital required (section A20.4 or A9.14 of guidelines in Appendix BR 3) by reference to credit risk in accordance with these regulations, excluding equity securities in the trading book and all positions in commodities. This figure will constitute minimum capital required to cover credit risk (section A20.5 of guidelines in Appendix BR 3). CA Secondly, the banks should calculate minimum capital required (section A20.9 or A17.14 of guidelines in Appendix BR 3) by reference to the measure of market risk (i.e. specific risk plus general market risk) in accordance with the regulations contained in section CA 1.4. This figure will constitute minimum capital required to cover market risk (section A21.10 of guidelines in Appendix BR 3). CA Thirdly, the amount resulting from the above requirement (section A20.10 of guidelines in Appendix BR 3) should be multiplied by 28.57%. This is the minimum capital charge which should be supported by Tier 1 capital allocated to market risk weighted exposures (section A20.12 of guidelines in Appendix BR 3); therefore, the balance amount in Tier 1 capital should be the amount allocated to support credit risk weighted assets (section A20.6 of guidelines in Appendix BR 3). CA The balance of the credit risk weighted assets may be supported by Tier 2 capital amount in section A20.7 of guidelines in Appendix BR 3 (subject to constraint stated in section CA 2.3). CA Further, the residual amount in Tier 2 capital (section A20.13 of guidelines in Appendix BR 3) may be used to support the balance subject to the condition stated in paragraph CA Section: CA 2.4: Calculation of the CAR for Islamic banks January 2005 Page 1 of 1

31 CHAPTER CA 2: The capital requirement CA 2.5 Minimum capital ratio requirement CA The Agency has established that the minimum capital ratio required for all Islamic banks incorporated in Bahrain is 12%. Furthermore, on a solo basis, the parent bank of a group is required to maintain a minimum RAR of 8.0% (i.e. unconsolidated). Maintaining minimum RAR CA All locally incorporated banks must give the Agency immediate written notification of any actual breach by such banks of either or both of the above RARs. Where such notification is given, the bank must also provide the Agency: (a) (b) no later than one calendar week after the notification, with a written action plan setting out how the bank proposes to restore the relevant RAR(s) to the required minimum level(s) set out above and, further, describing how the bank will ensure that a breach of such RAR(s) will not occur again in the future; and with a weekly report thereafter on the bank's relevant RAR(s) until such RAR(s) have reached the required target level(s) set out below. CA In addition, the Agency considers it a matter of best practice that, in order to ensure that these RARs are constantly met, that banks set up internal "targets" of 12.5% (on a consolidated basis) and 8.5% (on a solo basis) to warn them of a potential fall by the bank below the Agency's required minimum RARs as set out above. CA Where a bank's capital ratio falls below its target ratio, the General Manager should notify the Director of Banking Supervision at the Agency immediately. No formal action plan will be necessary, however the General Manager should explain what measures are being implemented to ensure that the bank will remain above its minimum RAR(s). CA The bank will be required to submit the PIRI forms to the Agency on a monthly basis, until the RAR(s) exceeds its target ratio(s). Section: CA 2.5: Minimum capital ratio requirement January 2005 Page 1 of 2

32 CHAPTER CA 2: The capital requirement CA The Agency will notify banks in writing of any action required of them with regard to the corrective and preventive action (as appropriate) proposed by the bank pursuant to the above, as well as of any other requirement of the Agency in any particular case. CA Banks should note that the Agency considers the breach of RARs to be a very serious matter. Consequently, the Agency may (at its discretion) subject a bank which breaches its RAR(s) to a formal licensing reappraisal. Such reappraisal may be effected either through the Agency's own inspection function or through the use of Reporting Accountants, as appropriate. Following such appraisal, the Agency will notify the bank concerned in writing of its conclusions with regard to the continued licensing of the bank. CA The Agency recommends that the bank s compliance officer supports and cooperates with the Agency in the monitoring and reporting of the capital ratios and other regulatory reporting matters. Compliance officers should ensure that their banks have adequate internal systems and controls to comply with these regulations. Section: CA 2.5: Minimum capital ratio requirement January 2005 Page 2 of 2

33 CHAPTER CA 3: Credit risk CA 3.1 Introduction CA This chapter describes the standardised approach for the measurement of the credit risk exposure in the bank s banking book. CA As illustrated in sections CA 3.2 and CA 3.3, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative risk. Section: CA 3.1: Introduction January 2005 Page 1 of 1

34 CHAPTER CA 3: Credit risk CA 3.2 Risk weighting On-balance-sheet asset category CA Risk weights by category of on-balance-sheet asset are illustrated in the table below: Risk weights 0% Category of on-balance-sheet assets/claims (a) Cash; (b) Holdings of Gold bullion and coins; (c) The government of Bahrain & Bahrain public sector entities; (d) Government-owned GCC companies incorporated in Bahrain; (e) Central governments and central banks of GCC and OECD countries; and (f) Central governments and central banks of classified countries where denominated and funded in local currency. 20% (a) Cash items in process of collection; (b) Multilateral development banks; (c) Banks and securities firms incorporated in Bahrain, other GCC and OECD countries; (d) Banks incorporated in classified countries with a residual maturity less than 1 year; (e) Public sector entities in GCC and OECD countries; and (f) Government-owned GCC companies incorporated outside Bahrain. Section: CA 3.2: Risk weighting - On-balance-sheet asset category January 2005 Page 1 of 2

35 CHAPTER CA 3: Credit risk Risk weights Category of on-balance-sheet assets/claims (continued) 50% Mortgages backed by residential property 100% (a) Related parties (b) Holdings of other banks and securities firms capital instruments (c) Banks incorporated in classified countries with a residual maturity of over 1 year (d) Central governments and central banks of classified countries (not included above) (e) Public sector entities of classified countries (f) Government-owned companies in non-gcc countries (g) Private sector persons and entities in and outside Bahrain (h) Istisna a assets* (i) Ijarah / Ijarah Muntahia Bittamleek assets (j) Real estate investments (k) Other assets not reported elsewhere** * This represents balance in Work in Progress/ cost account less billings. However, Istisna'a receivables should be reported against the risk weighting category of the counterparty. ** Salam Contracts are subject to market risk and should not be included here. Section: CA 3.2: Risk weighting - On-balance-sheet asset category January 2005 Page 2 of 2

36 CHAPTER CA 3: Credit risk CA 3.3 Risk weighting Off-balance-sheet items CA CA CA The framework takes account of the credit risk on off-balance-sheet exposures by applying credit conversion factors to the different types of off-balance-sheet instruments or transactions. The conversion factors are derived from the estimated size and likely occurrence of the credit exposure, as well as the relative degree of credit risk as identified in the Basel Committee s paper on "The management of banks' off-balance-sheet exposures: a supervisory perspective" (see issued in March The credit conversion factors applicable to the off-balance-sheet items are set out in the table below: Credit Off-balance-sheet items Conversion factors 100% Direct credit substitutes 50% Transaction-related contingent 20% Trade-related contingencies 100% Sale and repurchase agreements 100% Forward asset purchases 50% Underwriting commitments 50% Commitments with an original maturity of over 1 year, not unconditionally cancellable at anytime 0% Commitments with an original maturity of less than 1 year, unconditionally cancellable at anytime Section: CA 3.3: Risk weighting - Off-balance-sheet items January 2005 Page 1 of 2

37 CHAPTER CA 3: Credit risk CA The applicable credit conversion factors should be multiplied by the weights applicable to the category of the counterparty as set out below: Risk Counterparty weights 0% Type (a) 20% Type (b) 100% Type (c) - The Government of Bahrain. - Bahrain public sector entities. - Government-owned (non-banking) GCC companies incorporated in Bahrain. - Central government and central banks of GCC and OECD member countries. - Banks incorporated in Bahrain or GCC and OECD countries and securities firms. - Banks incorporated in classified countries (if the commitment has a residual life of 1 year or less). - Public sector entities in GCC and OECD countries. - Government-owned (non-banking) GCC companies incorporated outside Bahrain. - Banks incorporated in classified countries (if the commitment has a residual life of more than 1 year). - Central governments, central banks and public sector entities in classified countries. - Government-owned companies incorporated in non- GCC countries. - Private sector persons and entities in Bahrain and abroad. Section: CA 3.3: Risk weighting - Off-balance-sheet items January 2005 Page 2 of 2

38 CHAPTER CA 4: Equity risk CA 4.1 Introduction CA This chapter sets out the minimum capital requirements to cover the risk of holding or taking positions in equities in the bank s trading book. CA The minimum capital requirement for equities is expressed in terms of two separately calculated charges, one relating to the specific risk of holding a long position in an individual equity, and the other to the general market risk of holding a long position in the market as a whole. CA Where the bank has invested in shares/units of equity funds on Mudaraba financing and the bank has direct exposures in the equities which are traded in a recognised stock exchange, the shares/units are considered to be subject to equity risk. The equity position would be considered to be the net asset value as at the reporting date. Section: CA 4.1: Introduction January 2005 Page 1 of 1

39 CHAPTER CA 4: Equity risk CA 4.2 Specific risk calculation CA Specific risk is defined as the bank s gross equity positions (i.e. the sum of all equity positions and is calculated for each country or equity market). CA The capital charge for specific risk is 8%, unless the portfolio is both liquid and well-diversified, in which case the capital charge will be 4%. To qualify for the reduced 4% capital charge, the following requirements need to be met: (a) (b) (c) The portfolio should be listed on a recognised stock exchange; No individual equity position shall comprise more than 10% of the gross value of the country portfolio; and The total value of the equity positions which individually comprise between 5% and 10% of the gross value of the country portfolio, shall not exceed 50% of the gross value of the country portfolio. CA To qualify for reduced 4% capital charge on equity funds, the bank should acquire prior written approval from the Agency. Section: CA 4.2: Specific risk calculation January 2005 Page 1 of 1

40 CHAPTER CA 4: Equity risk CA 4.3 General risk calculation CA The general market risk is the difference between the sum of the long positions and the sum of the short positions (i.e. the overall net position) in each national equity market. In other words, to calculate the general market risk, the bank should sum the market value of its individual net positions for each national market, taking into account whether the positions are long or short. CA The general market equity risk measure is 8% of the overall net position in each national market. Section: CA 4.3: General risk January 2005 Page 1 of 1

41 CHAPTER CA 5: Foreign exchange risk CA 5.1 Introduction CA This section describes the standardised method for calculation of the bank s foreign exchange risk, and the capital required against that risk. CA The measurement of the foreign exchange risk involves, as a first step, the calculation of the net open position in each individual currency including gold 1 and as a second step, the measurement of the risks inherent in the bank s mix of assets and liabilities positions in different currencies. CA A bank that holds net open positions (whether assets or liabilities) in foreign currencies is exposed to the risk that exchange rates may move against it. The open positions may be either trading positions or, simply, exposures caused by the bank s overall assets and liabilities. Where the bank is involved in option transactions, these should be agreed in advance with the Agency. The Agency will consider the appropriate treatment on a case by case basis. CA The open positions and the capital requirements are calculated with reference to the entire business (i.e. the banking and trading books). CA The open positions are calculated with reference to the bank s base currency, which will be either Bahraini Dinars (BD) or United States dollars (USD). CA In addition to foreign exchange risk, positions in foreign currencies may be subject to credit risk which should be treated separately. 1 Positions in gold should be treated as if they were foreign currency positions, rather than commodity positions, because the volatility of gold is more in line with that of foreign currencies and most banks manage it in a similar manner. Section: CA 5.1: Introduction January 2005 Page 1 of 1