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Basel III could help boost Islamic banks' capitalization, liquidity management, says S&P

August 18, 2014

Standard & Poor's Ratings Services believes the Islamic Financial Services Board's (IFSB) revised capital  requirements for Basel III could help to strengthen the Islamic finance industry according to its report Basel III Offers An Opportunity For Islamic Banks To Strengthen Their Capitalization And Liquidity Management.

The December 2013 IFSB-15 standard for Islamic financial institutions sets out how Islamic banks will implement Basel III. The IFSB is likely to release its guidance note on the parameters and calculation of the liquidity coverage ratio and net stable funding ratio in early 2015. In our opinion, the introduction of a liquidity coverage ratio might address some of the industry's long-standing weaknesses, particularly the lack of high quality liquid assets (HQLA).

"Our base-case scenario assumes that there will be no major changes in Islamic banks' quality of capital, which we see as strong on average," said Standard & Poor's credit analyst Mohamed Damak. At the same time, we believe that raising capital requirements through the introduction of new capital buffers will help to make the industry more resilient," he explained.

"These buffers will ultimately help Islamic banks to cope better with the cyclical nature of the economies of the countries in which they operate and major business activities. Most of the Islamic financial institutions that we rate operate in emerging economies and also tend to have fairly significant exposure to the real estate sector.

"While we continue to view the liquidity of the Islamic financial institutions that we rate as adequate on average, we think that Basel III implementation creates an opportunity for the industry to develop a new range of HQLA to address the chronic lack of such instruments."

Over the past few years, the Central Bank of Malaysia has tackled the lack of HQLA by becoming the largest issuer of short-term Sukuk, providing Malaysian Islamic banks with much needed liquidity management instruments. Other central banks, the International Islamic Liquidity Management Corporates (IILM), and the Islamic Development Bank (IDB) may follow suit, providing the industry with new liquidity management instruments. Basel III implementation may also encourage highly-rated sovereigns and corporates to list their sukuk on developed and liquid markets to make them eligible for HQLA inclusion.

The implementation of Basel III will also test the treatment of profit sharing investment accounts (PSIAs) from liquidity and funding perspective. PSIA holders are, in theory, obliged to share any losses, but this could increase their volatility and liquidity coverage requirements and reduce their role as stable funding sources.

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Source: CPI Financial

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