The Implementation of Basel Standards

Given KSA’s unique regulatory environment, where Islamic and conventional banks are required to comply with the same laws and regulations, SAMA has consistently exercised its powers under the BCL and SAMA Charter to implement Basel requirements, with a few exceptions, such as the definition of high quality liquid assets or securities.496 In some instances, SAMA has also imposed stricter requirements than those recommended by the BCBS. It is argued here that this ensures that the unique risks embedded in some Islamic products are covered.

SAMA has issued regulations based on Basel II (as amended) and Basel III, with no challenge to the validity of the regulations in any court of law.497 Thus, Islamic banks in KSA, including Al Rahji Bank, the largest Islamic bank in the world,498 have avoided raising the issue with SAMA of these standards not being tailored towards Islamic finance. This is regardless of the fact that it should have happened, if these banks had felt compelled to apply standards that did not comply with Shariah, because neither the Charter nor the BCL grants legal protection to SAMA in either its regulatory or supervisory capacity. SAMA requires the Basel framework to be applied to every tier within each banking group, including foreign banks that are active on a fully consolidated basis.499 _{The objective here is to capture risk in a}

holistic way and to ensure that banks’ risk exposure is backed by high quality capital. This amounts to an attempt to ensure that each bank maintains a level of capital that is commensurate with its risk profile. In July 2009, SAMA issued Circular No. BCS 769, which specifically required banks in KSA to devise policies and set up systems and processes that are compliant with Basel II Standards. It also included guidelines in this regard. In December

496 _{BCBS, Regulatory Consistency Assessment Programme (RCAP): Assessment of Basel III Liquidity Coverage}

Ration Regulations – Saudi Arabia (BCBS 2015) 4. This is because the Basel standard requires assets it considers high quality liquid assets to be traded in large and active markets that have a low level of concentration. However, there is no liquid market in KSA for such assets.

497 _{Ibid, 19.}

498 _{In 2008, this bank had Shariah-compliant assets that totaled about 44 billion US dollars and represented 31.8}

per cent of the Islamic banking market of the KSA. See FA Lone, Islamic Banks and Financial Institutions: A Study of their Objectives and their Achievements (Palgrave Macmillan 2016) sections 2.3 and 3.7.

499 _{See H Banafe and R McLeod, The Saudi Arabian Monetary Agency, 1952-2016: Central Bank of Oil}

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2012, SAMA issued its Final Guidance on the implementation of capital reforms under the Basel III framework and in July 2014, it issued its Final Guidance on the implementation of the Basel III internal ratings-based approach to credit risk.500

In short, SAMA has generally reproduced Basel III requirements to enhance the management of credit risk, market risk, operational risk and liquidity risk by banks in KSA. For example, Circular No BCS 5611 requires KSA banks to comply with Basel III’s rules on the point of non-viability. Hence, any bank seeking to issue an additional Tier 1 or Tier 2 capital instrument must adopt a contractual loss absorption mechanism, which can be activated by the bank’s non-viability or a trigger event. However, it is important to note here that Basel III’s requirements regarding non-viability do not apply, where local laws require Tier 1 and Tier 2 instruments to be written off on the point of non-viability. Thus, rather than enact regulations to such effect, which would ensure that the instruments fully absorb any losses before they become systemic, SAMA has opted to reproduce the Basel requirements. SAMA has likewise reproduced Basel III requirements on capital conservation and countercyclical buffers.501

The Basel Liquidity Coverage Ratio therefore applies to all 13 nationally licensed banks in KSA, whether Islamic or conventional. The first liquidity coverage ratio standard was introduced by SAMA through Circular No. BCS 7390 of 8 February, 2012. Three major revisions were issued over three subsequent years. The effect of the Circular and regulations was that all commercial banks in KSA are subject to Basel III liquidity coverage ratio standards, with SAMA being able to impose corrective measures or fines in the event of breach. It may also take supervisory action to ensure compliance with its regulations.

Interestingly, the way in which SAMA regulates both Islamic and conventional banks using the same instruments has not resulted in any deviation from the Basel Standards.502 For example, SAMA has issued a Circular to banks stipulating the implementation of Basel principles for sound liquidity risk management (Sound Principles) and application of liquidity monitoring tools. The Sound Principles were introduced through Circular No. 771 of December 2008, requiring all commercial banks to assess their level of compliance with these

500 _{Copies of these circulars and the guidelines can be found on SAMA’s website.}

501 _{BCBS, Assessment of Basel III Risk-Based Capital Regulations: Saudi Arabia (BCBS 2015) 11-12.} 502 _{Ibid, 5.}

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Principles.503 Nonetheless, although Basel II (para. 651) encourages banks to comply with these Principles using the basic indicator approach, SAMA imposes compliance on banks in KSA. The basic indicator approach is a risk measurement technique that is suitable for banks with non-significant international operations; banks are required to hold capital for operational risk that is equal to the average over the past three years of a fixed percentage of positive gross income for each year.504 It must however be noted that the BCBS published a revised standardised approach for operational risk in December 2017. This replaces the approach in the Basel II framework. It is based on the Bank Indicator or a measure of the bank’s income, and the Internal Loss Multiplier or a measure of the bank’s historical losses.505 Nonetheless, SAMA’s guidelines complement the approaches in the Basel II and Basel III frameworks. Given that Islamic banks in KSA do not have significant international operations beyond the Cooperation Council for the Arab States of the Gulf (GCC) countries, the imposition of the basic indicator approach on all banks is of benefit to the Islamic banks. What emerges over the course of this clarification is the requirement for KSA banks to set up processes for the active management of liquidity risk. In this regard, SAMA has issued guidelines that complement Basel II’s Pillar II stress test.506 The objective of this is to ensure that each bank operates at a level of risk that is commensurate with its liquidity profile. The bank must also maintain an adequate level of liquid assets, clearly determining its liquidity risk tolerance and devising an appropriate strategy to maintain its stability. Equally, SAMA requires the involvement of senior management to define, approve and monitor the above processes, similar to the recommendations of the BCBS.507

Out of all the Sound Principles, one of the most important is Principle 13, which requires banks in KSA to disclose liquidity-related information to the public on a regular basis. This is intended to enable market participants to assess the soundness of each bank’s risk management strategy and liquidity position.508 This disclosure is beneficial to Islamic banks, because (as noted in Chapter 4), certain important Islamic modes, such as the Mudarabah and

Musharakah require a high level of financial disclosure and transparency, in that the parties

503 _{For an overview of the Principles, see BCBS, Principles for Sound Liquidity Risk Management and}

Supervision (BCBS 2008) 6-36.

504 _{See K Sophastienphong and A Kulathunga, Getting Finance in South Asia 2009: Indicators and Analysis of}

the Commercial Banking Sector (The World Bank 2008) 88.

505 _{See BCBS, Basel III: Finalising Post-Crisis Reforms (BCBS 2017) 128-133.} 506 _{Stress-testing in the KSA is discussed below.}

507 _{This is also in accordance with Principles 2-4 of the Sound Principles. See BCBS, note 498 above, 32.} 508 _{Ibid, 33.}

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need to be thoroughly informed about the capital and in a manner that minimises or eliminates any possibility of ambiguity or uncertainty.

Liquidity monitoring tools were introduced in KSA through Circular No. 351000147086, issued in September 2014. This Circular proposed a specific risk management strategy for adoption by banks. For example, banks are required to define their monitoring tools as part of the risk management process and submit monthly returns. These tools capture specific data on certain market indicators, as well as on cash flow, the quality of any available unencumbered assets, and the balance sheet structure of each bank. These data help supervisors assess the liquidity risk of each bank. Thus, the tools monitoring contractual maturity mismatch profiles identify any gaps indicating the amount of liquidity each bank must raise in each specific time band. Banks must also identify any sources of wholesale funding that are of such importance that withdrawal of the funding could cause serious liquidity problems. This is very important for Islamic banks, given that in PLS equity-based agreements, the Rabbul-Maal may withdraw their money from the fund at any time.

SAMA is empowered by the BCL to conduct regular on-site inspections. Banks are consequently required to provide information on their risk management processes, while SAMA may thereby evaluate their operations and systems of internal control and management. SAMA therefore regularly assesses all commercial banks in KSA to identify any risks that they might be exposed to, while at the same time ensuring that they maintain adequate liquid assets and operate at a level of risk that is commensurate with their liquidity profile. It follows that SAMA is justified in implementing the same regulations with regard to both Islamic and conventional banks, since any bank that does not maintain an adequate level of liquid assets is likely to confront problems of illiquidity, irrespective of whether or not its processes are Shariah-compliant.

Notwithstanding the above, the uniqueness of Islamic finance cannot be overlooked. It was demonstrated in Chapters 3 and 4 that Islamic banks confront special risks embedded in PLS agreements, which require relevant credit-scoring models and unique methods of measuring any risks that may be duly assessed by regulators. The problem posed by standardised approaches, such as Basel II and Basel III, as well as the IFSB Principles discussed in Chapter 3, is that they are generic and do not address the unique difficulties faced by Islamic banks as a result of restrictions imposed by Shariah. In light of SAMA’s implementation of the Basel Standards described above, the following subsection looks at how the risk profile of

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Islamic products and services may be assessed, taking into account the peculiar nature of Islamic finance.