Risk-Weighting Alternatives

2.5.2. Risk-Weighting Alternatives

Most Islamic banks are at present supervised within the framework of the existing standardised approach, namely, the 1988 Basel Accord on capital requirements and the accompanying supervisory framework contained in the 1997 Core Principles. There are strong indications, particularly from Iran, Pakistan and Sudan, that Islamic banks will be required to strengthen their existing capital and to adopt international standards. As discussed above, the part of the existing Accord which relates to the risk-weighting of assets for determination of capital requirements, has been changed and the changes are expected to be implemented starting from the year 2001. Depending on the supervisory assessment of banks’ risk management capabilities, these changes would give the banks the option to adopt either a) the external credit assessment-based standardised approach, b) the internal ratings-based approach, or c) the models- based approach. In the first case, supervisors will continue to assess and determine capital requirements for banks, and in the last two approaches, qualified banks will be allowed to assess their own capital requirements subject to the supervisory review process and verification. The ultimate objective is to develop risk management culture in banks by requiring lesser capital for the adoption of appropriate policies by banks.

What would be the best risk-weighting choice for Islamic banks? If Islamic banks aim at being competitive world-wide and gaining acceptance from international standard setters, these banks have no other choice but to choose from these three approaches. The adoption of any one of these approaches will first depend on the capabilities and preferences of banks and the subsequent supervisory review and follow up. The following three considerations make it preferable for Islamic banks to apply the internal ratings-based approach.

i. The difference in the nature of Islamic modes of finance makes the risks of Islamic banks’ assets different from those created by

interest-based lending. This makes the risk-weighting system more complex in assessing the quality of assets. This is because assets are not risk-weighted individually in the existing Basle system, but interest-based lending. This makes the risk-weighting system more complex in assessing the quality of assets. This is because assets are not risk-weighted individually in the existing Basle system, but

possible to develop an index of the assets’ risks. 53 This index could

be used to determine the capital requirement for each asset, to be aggregated afterwards for determining the overall capital requirement.

ii. The internal ratings-based approach allows each bank to develop its own risk management system and culture. This will make it

possible for Islamic banks to develop systems which can meet the peculiar requirements of the Islamic modes of finance.

iii. The diverse nature of Islamic modes of finance, inadequate development of risk management systems, and requirement for

risk-sharing make it incumbent upon Islamic banks to allocate more resources to risk management as compared with their conventional counter-parts. Hence the internal ratings-based approach seems to

be most conducive to the development of a risk management culture.

However, choice of the internal ratings-based system depends on supervisory approval. This approval would be based on the existence of required capabilities within the banking institution. Given the small size of most Islamic banks and their inadequate risk management capabilities, we do not expect many of them to be able to initially qualify for this most desirable approach. Therefore, most Islamic banks could initially be supervised within the framework of the external credit assessment-based standardised approach. Moreover, the lack of ratings or external source of credit assessment for the clients of most Islamic banks is also a serious limitation. The new standardised approach handles this limitation by allowing 100% risk-weight to assets for which no external credit assessment is available. It may therefore, be suggested that, even if the Islamic banks have to start with the second-best approach, it would

53 Several studies are available on the index; see for example, ISDA (2000).

be desirable for them to quickly graduate into the first-best approach. As far as the models-based approach is concerned, it is too early at this stage for Islamic banks to fully rely on this approach. However, it would again be in the interest of these institutions to start familiarising themselves with these approaches and building the capability for the application of computer-based models.