Optimality In Basel 3: A function of Profit generation and Credit Creation Within Sectors' Allocation in Islamic Banking
By Ma'an Barazy
Certified Islamic Sharia Advisor and Auditor – AAOIFI – President/CEO Data and Investment Consult Lebanon – The Center for Islamic Finance
ABSTRACT : Capitalizing on the idea that challenge the idea that financial innovation is axiomatically beneficial in a social as well as private opportunity sense ; a non socially optimable case for Islamic finance this paper looks into the process of lending and suggest that new regulatory measures under Basel III may push banks to approve of any credit creation in excess of banks' capital. The Basel Committee has proposed strengthening considerably both the quantity and the quality of capital in the global banking system. This would mean much larger core equity capital for all banks and a range of additional reserves—a capital conservation buffer, a countercyclical buffer, and a surcharge for systemically vital institutions—to be added by local regulators as they see fit. Islamic Banking involving such credit creation is arguably, therefore, a contradiction in terms. Basel III requires banks to hold more capital than actually needed in their buffer requirements. That won't be easy for rich country banks, given that growth prospects are dim in the medium term and markets are under stress; however the process will require them to do what they are already doing, namely, meet capital norms by shrinking their balance sheets. In contrast, banks in emerging markets can hope to raise capital on the strength of high loan growth and attractive returns to assets. They should be able to marry higher capital adequacy with growth- and, in the process, narrow the difference in market capitalisation over the next five years or so.
Thus, under Basel III [1], capital promises to be a source of competitive advantage- for some emerging market banks. This paper builds along[2] Adair Turner, Chairman, FSA speech at Southampton University and similarly argue that we certainly need to base macroprudential policy and other aspects of policy on realistic assessments of the extent to which private credit creation processes can be relied upon to be socially optimal, a key tenet for Islamic banking The fundamental question which I ask is how confident can we be that the quantity of bank credit supplied and demanded, and the allocation of that credit to different sectors or activities will be socially optimal, another intention of finance under Islamic banking. This paper also might want to argue that if we leave the credit creation and allocation process to free market mechanisms, subject only to the indirect levers of static prudential controls and to interest rate based monetary policy social optimality will not obtain. Further it holds that Islamic Banks must assess their overall funding, capital, and leverage position and determine how much of the new requirements can be met internally, for example, by generating additional capital and funding from the current businesses, as well as externally from capital markets. Inasmuch as they remain constrained under these resources, their focus will inevitably turn toward exiting the least attractive businesses, as measured by return on risk-adjusted capital, even if the business is meeting its internal hurdle rate.
KEYWORDS: Liquidity Risk; Islamic Compliance; Sukuks; Debt; Basel Laws; Maqasid Al Shari'ah
[1] the first Capital Accord, Basel I. Basel I established the requirement for financial institutions to have total capital of at least 8% of risk-weighted assets (RWA). The Basel II framework released in June 2004 added a capital charge for operational risk, required that supervisors focus on main risks in the banking system for calculating capital requirements and required enhanced disclosure requirements, including each financial institution's risk exposures and risk assessment processes.
[2] Speaking at a European conference on banking and the economy at Southampton University, Lord Turner said that the financial crisis had in part derived from new features of the financial system, such as trading in complex credit securities and derivatives, and argued that further regulatory action to address the risks created by these activities was still required. He highlighted further changes to the capital regime for trading activities, and the international Financial Stability Board's project to identify required actions in relation to "shadow banking". But he stressed that banking crises and harmful swings in economic activity can also be produced by volatility in the core functions of the banking system such as extending loans to customers. In the case of the major banks which had failed in the UK, failures in plain old fashioned banking were as important as failures in new trading activities.
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