THE APPLICABILITY OF BASEL STANDARDS IN ISLAMIC BANKING

S ciljem stabilizacije bankarskog sistema na nacionalnom i globalnom nivou i sprečavanja razornih kriza koje se vrlo brzo sa finansijskog prelivaju na realni sektor, usvojeni su Bazelski standardi adekvatnosti kapitala i upravljanja rizicima, koji su implementirani u izvornoj ili delimično izmenjenoj formi u velikom broju zemalja. Rastuće prisustvo i značaj islamskih banaka uslovili su povećanu pažnju stručne javnosti prema svim aspektima poslovanja ovih finansijskih institucija. Jedan od ključnih aspekata poslovanja islamskih banaka je efikasnost održavanja adekvatnog nivoa kapitala i upravljanja rizicima. Uzimajući u obzir specifičnost islamskog finansijskog posredovanja i poslova koje islamske banke realizuju, postavlja se pitanje da li su Bazelski propisi i praksa konvencionalnih banaka u upravljanju kapitalom i rizicima primenjivi u islamskim bankama. U radu ćemo analizirati mogućnosti islamskih banaka da, ne odstupajući od bazičnih šerijatskih principa, primene Bazelske standarde prilikom strukturiranja kapitala, kontrole ispoštovanosti standarda adekvatnosti kapitala i izveštavanja o uspešnosti upravljanja kapitalom i rizicima.


Introduction
The amount of bank capital is one of the main criteria by which the regulatory authorities, depositors, clients, the competition and the public estimate the business capacities and possibilities of a bank.Bank capital represents the financial basis necessary for the establishment of a bank, but also a base for sustainable growth and development, attracting and keeping clients and meeting the regulatory requirements (Rose, 2003, p. 471-472).The Basel Committee on Banking Supervision (BCBS), for exactly these reasons, based its concept of protecting and managing bank risks on bank capital, i.e. the capital to assets ratio of a bank.By the end of the 1980s, the BCBS adopted a set of globally applicable capital adequacy standards, which define the capital structure, the process of determining risk weighted assets and minimum capital requirements (BCBS, 1988).During the 1990s a couple of amendments were added to the initial version of the Basel standards.Firstly, the financial derivatives were taken into consideration (BCBS, 1995), and then the capital structure was expanded by adding Tier 3, and the list of risks, whose effects on the bank's business have been analyzed was expanded by adding market risks to the already represented credit risk, (BCBS, 1996).Soon afterwards the document dealing with the transparency of banks' business was adopted, too (BCBS, 1998).
Certain shortcomings of the first set of Basel standards encouraged the Basel Committee to adopt a revised framework for capital management (BCBS, 2004).This document brought significant innovations by defining the three pillars of capital adequacy: Pillar 1 -minimum capital requirements, Pillar 2supervisory review of capital adequacy and Pillar 3 -the market discipline.When it comes to Pillar 1, the changes were made in respect of determining the risk weighted assets, by taking into consideration the bank's exposure to operational risk as well, and defining the new approaches to determining credit risk capital requirements.Pillar 2 is aimed at controlling if the regulations are followed when it comes to the capital adequacy in banks, while Pillar 3 is concerned with publishing the information about the bank business, necessary for estimating its risk level and capital adequacy.However, despite the significant progress that was made with a new set of standards, numerous flaws and omissions of this set of standards occurred subsequently, which was particularly evident during the global financial crisis.In order to additionally improve the global framework of capital and risk management, and to make the banking systems more resistant to the occasional financial market shocks the Basel Committee adopted a couple of documents (BCBS, 2009(BCBS, , 2010(BCBS, , 2011(BCBS, , 2013) ) increasing the capital requirements and particularly stressing liquidity management, which was significantly jeopardized in many banks during the crisis.
Standard koji je formulisao Odbor za Islamic Financial Services".Only Pillar 1 of capital adequacy was defined in this document (minimum capital requirements), while Pillars 2 and 3 were not the subject of analysis.The process of determining capital adequacy is based on defining the regulatory capital and risk weighted assets.The IFSB demands that the minimum capital adequacy ratio for Islamic financial institutions must be 8% and that the Tier 2 capital is limited to 100% of Tier 1 capital.The standards formulated by the IFSB do not define the elements of the Tier 1 and 2 capital.Certain theoreticians of Islamic banking (Obaidullah, 1997, p. 50) consider that it is natural for common capital to be an element of the bank's Tier 1 capital, while investment deposits, in line with their characteristics, are rather an element of Tier 2 capital.Yet, the inclusion of investment deposits in Tier 2 capital is considered inappropriate by both the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and a considerable part of professional public (Grais & Kulathunga, 2007).By analyzing the structure of regulatory capital in many Islamic banks (Abu Dhabi Islamic Bank, Al Rajhi Bank, Bahrain Islamic Bank, Dubai Islamic Bank, Qatar Islamic Bank), we have concluded that Tier 1 capital, with small deviations, possesses almost identical elements as all the observed Islamic banks.However, it is noticeable that the structure of Tier 1 capital varies from one Islamic bank to another, whereby some banks do not state the applied structure of this Tier, which indicates the inconsistency of regulations and practice of Islamic banks in different countries.Besides that, the Basel formulation of the structure of Tier 2 capital includes certain elements inappropriate by the Sharia, such as the interest bearing loans and preferred stocks, which cannot be found in the capital structure of Islamic banks.Finally, the structure of Tier 3, which is based on conventional debt according to the Basel standards, is ultimately unacceptable by the Sharia, and, therefore, most of the suggested regulatory capital structures of Islamic banks only include Tier 1 and 2 capital.
The Islamic Financial Services Board (IFSB, 2005, p. 3) did not neglect the uniqueness of Islamic bank investment deposits, in which banks do not establish the debtor-creditor relationship with their depositors, typical for conventional banks, but instead form a partnership.Considering that the protection of deposits from the bank's business risks is one of the most important functions of capital, the amount of mandatory capital of Islamic banks needs to be considerably lower than in the case of conventional banks, because most of the depositors share the business risks with the bank.In practice, however, the holders of investment deposits are often unwilling to share the business risks with the bank, which is why Islamic banks are forced to create special reserves for insuring the return on deposits (Iqbal & Mirakhor, 2009, p. 224-226).

Supervizorska diskreciona formula
Lekpek A. Primenjivost Bazelskih standarda u islamskom bankarstvu and Diminishing Mushārakah, 6. Muḍārabah and 7. Sukūk held as investment.Islamic banks can determine the minimum capital requirements for operational risk by using the basic indicator approach or the standardized approach, using the gross income as a proxy indicator for the operational risk exposure.The IFSB defines gross income as a sum of the net income from financing activities, the net income from investment activities, and the fee income (commission and agency fee), deducted by the investment account holders' share of income.
The IFSB suggests multiplying the capital requirements for market risk and operational risk by 12.5.By incorporating the obtained values of regulatory capital and risk weighted assets into the capital adequacy ratio formula, the capital adequacy of a particular Islamic bank is determined.The IFSB has developed two capital adequacy ratio formulas: the standard formula and the supervisory discretion formula.
In the standard formula, investment deposits also cover the reserves for insuring the return on deposits (profit equalization reserves -PER and investment risk reserves -IRR).The supervisory discretion formula, on the other hand, provides a considerably better insight in the method of determining risk-weighted assets and the treatment of the assets funded by investment deposit sources and reserves.Considering that the owners of these deposits are the bank's partners, the IFSB estimated that the assets funded by these sources must be separately treated, which is why a part of the amount of the assets is deducted from the total risk-weighted assets.In the supervisory discretion formula the factor α is noticeable.This factor represents a part of the assets funded by the general investment deposits and its value is determined by the regulatory authorities.The amount of risk-weighted assets funded by investment reserves is also determined by this factor being deducted from the total riskweighted assets.
The Central Bank of Malaysia (Bank Negara Malaysia) is one of the rare institutions to take concrete actions in this sphere and define the Pillar 2 for Islamic banks.The Central Bank of Malaysia regulated the supervision of capital adequacy in Islamic banks with a set of standards called ,,The Capital Adequacy Framework for Islamic Banks -Internal Capital Adequacy Assessment Process (Pillar 2)".This document implies the double supervision of capital adequacy in Islamic banks, which should be conducted by the governing bodies of the banks themselves (internal assessment) and supervisors chosen by the central bank (external assessment).The management of Islamic banks is expected to create an efficient system of identification, assessment and reduction of risk effects and, in accordance with the estimated business risks, form and manage capital according to the valid regulations.The second part of the capital adequacy control is conducted externally by the supervisors who control the internal process of capital adequacy assessment.The supervisors' task is to estimate the success of the Islamic bank's administration in maintaining capital adequacy.The supervisors present their assessments to the central bank, which can make an intervention if the bank's capital is not at the requested level or if there is a danger it might not be in the foreseeable future.The situation is particularly critical when the banks, entering very risky business arrangements with potentially high yields, increase the share of risk-weighted assets in their total assets, without a necessary capital increase.

Market Discipline
Financial reporting of conventional financial institutions is coordinated with the international financial reporting standards.However, the current international financial reporting standards do not recognize the uniqueness of Islamic financial instruments.Using them in financial reporting of Islamic banks, the displays of Islamic financial transactions including the incomes and expenses, attempt to fit in the already existent patterns of conventional financial arrangements, which is why their uniqueness remains hidden.As a result, the financial reports of Islamic banks become nontransparent and hardly comparable, and universality of Islamic banks inadequately presented (Archer & Karim, 2007, p. 303-304).For Islamic banks, the transparency of financial reports is especially important, because they can attract new depositors, with whom they share profit and loss, new investors and clients only by informing the public about their business and the risks they meet on a regular basis, thereby eliminating the stereotypes accompanying their business (Ariffin, Archer & Karim, 2007, p. 168).The transparency imperative of financial reporting in Islamic banks has become more and more prominent during the past few years, due to the fact that Islamic banks have internationalized their business and included some sophisticated financial products in their portfolios, which has made their business a matter of new regulations (Hassan & Chowdhury, 2004, cited in Hassan & Dicle 2005, p. 9-10).On the other side, insisting on the adoption of the conventional financial reporting standards, which is very difficult to conduct in Islamic banks, resulted in a situation where Islamic banks selectively use certain conventional standards or their segments considered to be applicable to some of their business transactions, which is why financial reports of different Islamic banks are often impossible to compare (Archer & Karim, 2007, p. 304).
In order to overcome the problems in financial reporting of Islamic financial institutions, the Islamic Development Bank initiated the establishment of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), as an institution specialized for the development and enhancement of the financial reporting standards of Islamic financial institutions.This institution helps Islamic banks in making their financial reports by defining the accounting, auditing and Sharia principles for Islamic banks (Ariffin, 2005, p. 87-88).The goal za koje smatraju da su primenјivi kod pojedinih poslovnih transakcija, zbog čega su finansijski izveštaji različitih islamskih banaka često neuporedivi (Archer & Karim, 2007, str. 304).
However, in most countries where Islamic banks are operating, the national accounting standards for Islamic financial institutions are established, and the application of the AAOIFI standards is not mandatory (Faizullah, 2009, p. 94-95).Obviously, the regulatory authorities in the countries in which Islamic banks do business have neglected many advantages of the AAOIFI standards, such as the transparency and comparability of financial reports of Islamic banks and the relevance and reliability of the information the reports would be offering to the users (Karim, 2001, p. 189).The success of the AAOIFI in further developing the financial reporting of Islamic financial institutions will depend on the support it gets from the countries in which Islamic banks do business, i.e. their regulatory bodies.Such support is evident in establishing the special regulations and accounting standards that would be in accordance with the AAOIFI standards and mandatory for Islamic banks.
On the other hand, the critics of the AAOIFI standards believe that the financial reports prepared in accordance with these standards will be incomprehensible for most of the national and international regulatory agencies and potential business partners of Islamic banks, which is why the business of Islamic banks will be hindered and their shares and other securities underrated (Archer & Karim, 2007, p. 307).However, the practice has shown that, except for certain AAOIFI standards, whose purpose is to adequately present the Sharia compliant contracts, the compatibility between most of the AAOIFI standards and the international financial reporting standards is noticeable (Archer & Karim, 2007, p. 308).Still, the awareness about the needs of Islamic banks exists, which is proven by the decision to include the secretary general of the IFSB in the International Financial Reporting Standards Advisory Council, thus enabling the Islamic financial sector to take part in defining the future international accounting standards (Archer & Karim, 2007, p. 308).Although the development of new accounting standards, conditioned by the needs of Islamic banks, requests additional efforts, the achieved benefits, such as the advancement of accounting practice of Islamic banks, the reliability and comparability of financial reports (Hassan & Dicle, 2005, p. 10), are definitely worth the effort.Moreover, some theoreticians of Islamic banking (Kahf, 2005, p. 317) point out that the advancement of transparency in the Islamic banking business brings no more practical and theoretical difficulties than the improvement of transparency in the operations of conventional banks.

Conclusion
The use of the Basel capital adequacy standards in Islamic banks entails many challenges, some of which are impossible to overcome without the partial modification of the Basel rules and the adjustment to the needs and nature of Islamic banks.Islamic banks can only partially adopt the Basel structure of regulatory capital since they can only use the structure of Tier 1 capital, while Tier 2 and 3 capital are impossible to form in Islamic banks according to the Basel regulations.The reason for this is because Tier 2 and 3 are made of instruments that are unacceptable according to Sharia.This problem can be solved in two ways: 1. by forming capital consisting of only Tier 1 ( equity, retained profit and reserves), or 2. by structuring Tier 2 and 3 in accordance with Sharia.Most of Islamic banks chose the second solution, provided that the structure of Tier 2 is not standardized, but different in Islamic banks operating in different countries.Besides that, a sustainable solution for the structure of Tier 3 has not been discovered yet, which is why Tier 3 is rarely found in the structure of regulatory capital of Islamic banks.
do not have the adequate conditions for using the Basel risk assessment methods.Using the standardized approach has been made difficult by the lack of Islamic rating agencies that would be able to determine the Islamic banks' rating, taking into consideration all of the aspects of their business.On the other hand, the use of internal ratings-based approach is limited due to the unavailability of data on the past cases of the certain debtor's default.Furthermore, the Basel standards do not recognize the uniqueness of Islamic investment deposits and the relationship between their owners and Islamic banks.Islamic banks need considerably less capital to protect their depositors from the risk of losses than conventional banks, because the owners of investment deposits share both the business profit and loss with the bank.Therefore, the assets funded by investment deposit sources cannot be treated in the same way as the assets of conventional banks funded by interest-bearing deposits.In its capital adequacy regulatory framework the IFSB took into consideration this fact and treated the assets funded by investment accounts differently in the formula for the calculation of capital adequacy.
The capital adequacy standards, formulated by the IFSB, do not define Pillar 2 of capital adequacy.This way, the regulation of this issue is left to the countries in which Islamic banks operate, which additionally expanded the problem of not having any standardized regulations for Islamic banks.The regulations in most countries treat the capital adequacy of Islamic and conventional banks in the same way.Insisting on the Basel standards' usage in Islamic banking, without some necessary modifications, can only be counterproductive.Thus the form would be favored over substance, because the Islamic banks would formally adhere to the imposed regulations, but the regulatory capital and risk-weighted assets determined that way would not realistically represent the risk levels of the bank and whether the available capital is sufficient for the protection against the investment risks.
The international financial reporting standards, which are the basis for disclosure regulations set by Pillar 3, cannot be used in Islamic banks without some modifications, since they completely neglect the Sharia elements of Islamic financial transactions and instruments.This problem has been partially solved thanks to the AAOIFI standards of financial reporting.However, a long-term sustainable solution and the standardized practice of financial reporting of Islamic banks currently do not exist.The problem with the AAOIFI standards is that a relatively small number of countries has accepted them.Therefore, the Islamic banks preparing their financial reports in accordance with these standards could have problems when presenting those financial reports to foreign partners that are not familiar with the AAOIFI standards or to the regulatory authorities that do not accept them.Just like in the case of the capital adequacy supervision, insisting on the conventional financial reporting practice in Islamic banks would cause more damage than good.Without the disclosure of the Sharia aspects of the performed transactions, the business transparency of Islamic banks would be jeopardized.Still, the involvement of an Islamic banking sector representative in the International Financial Reporting Standards Advisory Council awakes the optimism that in the near future the international accounting standards will include the standards specifically adjusted to the needs of Islamic banks.