Capital Adequacy is a financial term that is used to define the regulatory guidelines that requires financial institutions such as banks to reserve certain percentage of their Primary Capital Base that is consistent with the institutions lending. A bank must ensure that it capital base assets is at a minimum of 8 percent of it assets, the rule of thumb that applies is lending of $12 for each single dollar of the bank’s capital, this is what is referred as Capital Adequacy Ratio (CAR) or at other times Capital to Risk Assets Ratio (CRAR) (FiMarkets 2009). The purpose of calculating capital adequacy is to ensure that a bank is not exposed to financial risks that are caused by the lending policy of the institution.
In many countries government regulations requires the financial institutions to comply with the minimum acceptable level of Capital adequacy which is the other reason why banks need to establish the CAR. The Basel Committee on Banking Supervision redefined the international Capital Adequacy standards on 2004 that are now used to regulate financial institutions (Rasmusen 1988). Determination of Capital adequacy in financial institutions is outlined in the first pillar of the second Basel accord. The purpose of this paper is to analyze the general implications of the Basel 1 and 2 accords on Islamic banks in Gulf region as well as explore in depth the Basel accords structure and recommendations.
Basel Convention on Capital Adequacy
The 1988 Basel I convention on capital adequacy was limited in terms of width and depth in the way that it approached CAR calculation. Basel I framework on Capital Adequacy was determined by two major factors that included credit risk and standard weight: standard weight calculation was limited in it calculations of weighted risks (FiMarkets 2009). Basel I accord focus, was therefore on setting the minimum possible capital levels for financial institutions and also ensuring that banks embraced low value assets as collateral. The flip side of this rationale was an increased risk to financial institutions brought about by incomplete analysis of the dynamic market parameters. In the years that followed Basel I accord was amended several times to incorporate and reflect changes in the financial sector. These changes further strengthened the current international financial regulations of banks from unforeseen risky outcomes.
One such amendment was in 1996 for market risk that saw the CAR expanded to incorporate the risks associated with other financial market force. However even then Basel I accord had still other inherent limitations (Basel 2000). The Capital Adequacy calculation for instance did not provide an accurate and reliable financial guideline for determination of CAR (Basel 2000). Another disadvantage under Basel I accord was the tendency of the banks to undertake regulatory capital arbitrage which enabled them to manipulate their core capitals in order to reflect favorable capital assets that made them compliant, lastly the accord did not offer ideal risk mitigations approaches to banks (Basel 2000). Hence Basel II was born in 2004 to address these shortcomings and incorporate other challenges that banks were facing in the financial sector.
Capital adequacy is a financial concept that has been very effective as a framework for mitigating risks that are associated with financial transactions for all types of conventional banks, and which the Islamic banking system has sought to embrace by customizing them in a way that provide the same advantages to their institutions. Although Islamic bank are not in the mainstream the impact they have on the world financial market is significant. By 2003 the General Council for Islamic Banks and Financial Institutions approximated the number of operational Islamic banks worldwide to be not less than 250 fully fledged financial institutions with operations in more than 50 countries and combined annual turnover of US$300 billion (Hassan 2004). At the time Islamic banking share market for financial transactions was also estimated at 15%, over the years we can only assume that this share has significantly increased as well as the number of new financial institutions.
The new Capital Adequacy calculation is guided by three core principles that are referred as pillars: market discipline, operational capital requirement, and supervisory review (Basel 2000). Pillar number one pertains to regulatory capital of three critical risks that a bank encounters during it routine financial operations: market risk, credit risk and operational risk. For each of this risk the accord provides various calculation techniques that set the desired level of accuracy such as standardized approach, foundation Internal Rating-Based (IRB) approach and advanced IRB for calculating credit risk (Basel 2000).
The second pillar tackles the other forms of risks that are not included within the first pillar but which financial institutions are more likely to encounter, such risks include liquidity risk, legal risks, concentration risk and pension risk. It also provides bank supervisory regulators with guidelines for determining bank compliance (Basel 2000). Pillar two also requires regulators to assist financial institutions in developing internal systems for determining their capital requirements. The last pillar focus is on market discipline which includes banking ethical standards and accepted business practices that promote bank financial stability.
The underlying working definition of capital categorizes banks equity into two groups: tier I capital and tier II capital. Tier I Capital is defined as the actual equity inclusive of retained earnings while Tier II Capital is the subordinated debt in addition to the preferred shares (Basel 2000). Tier I capital are financial institutions assets that can absorb financial losses of a bank during trading without necessitating the bank to enter into bankruptcy. Tier II capital are the other type of assets that are reserved primarily to absorb losses of large magnitude during the event of bankruptcy. While the current Basel II accord has gone a long way in addressing the unique financial characteristics of Islamic banks more adjustments to CAR are needed in order to fully cater for this form of banking system.
Reality of Islamic Bank under the Basel Resolution
Islamic bank is a term used to define financial institutions that are governed by tenets of Islamic laws and regulations. Islamic banking system is quite different from financial practices of mainstream banks. Modern Islamic Banking differs with former Classical Islamic Banking systems in various aspects particularly the interest free-banking system that is a recent feature of Islamic Banking, our focus in this case will be on modern Islamic banking. Basically Islamic banking is similar to mainstream banking in practice and in most other routine functions, however it differs in areas that pertains to interest, profit and loss sharing which are the central features of the banking system that sets it apart (El-Gamal 2005). These rules are governed by code of practices referred as Fiqh al-Muamalt, which describes the profit and loss sharing principles that are used by Islamic bank.
The Islamic banks approach to lending is very unconventional in that the bank does not give out the loan to a borrower per se, but instead acquire the asset on behalf of the borrower who is then supposed to institute repayment to the banks in installments; this is usually referred as Murabaha when the loan is made towards mortgage (El-Gamal 2005). Another unique feature of Islamic banking pertains to it approach on lending; it does not set out uniform interest rates for all companies but rather customize interest rates to match the company financial performance. This means companies with high profit returns are charged more, a concept defined by the floating rate interest on loan system (El-Gamal 2005). This values and features of Islamic banking are the backdrop in which we are going to analyze the Basel I and II accords.
The functions of Islamic banks goes beyond the mainstream banking functions in that an Islamic bank doubles up as a trader, investor and a consultant with mandates that goes beyond the traditional profit maximization concept (Hassan 2004).
As such the distinct nature of Islamic banking has advantages that arise as a result of it financial transactions and which is also it disadvantages. The major advantage of Islamic banking is confined to the banks concept of Profit and Loss Sharing (PLS), in this arrangement the banks depositors are strictly speaking not creditors to the bank per se, but rather very similar to shareholders who stand to absorb a certain percentage of the banks losses as outlined in the banking contract (Hassan 2004). The implication of this arrangement is that Islamic banks are more insulated from financial losses that emanate from depositors capital than their conventional counterparts. An anomaly that also interferes with CAR calculations, analysts have suggested this peculiarity be addressed by having the depositors capital shifted to the numerator so that it can be factored together with the tier capitals.
The disadvantages that are inherent in the Islamic banking system are proportional to the advantages that the bank enjoys in respect to the depositors funds. The same contract between the banker and the depositor that provides for risk sharing also contains components that protect the depositor from non-procedural banking operations that can results in losses. In such a case the bank is obligated to compensate the depositor with full deposited funds or face legal actions, in what is usually referred as Fiduciary Risk. Closely associated with this type of risk is Displaced Commercial Risk, a form of risk that Islamic bank are exposed to whenever they move to top up the depositors “perceived profit sharing”, to be at par with interests that the other banks are offering at the time (Hassan 2004).
This is despite the fact that the bank profits might not be sufficient to provide for such percentage but which they are compelled to pay or face depositor’s financial sabotage. In order to do this the bank has to re-allocate the bank shareholders funds by toppling their profit sharing obligations to cover the shortfall. Other areas that the bank faces risks are in areas of collateral, market risk, credit risk, and bank equity since Islamic bank significantly differ with universal banks in terms of funds mobilization. Indeed the current way in which Islamic banks calculate CAR is an indicator of their unique banking system. Because of Ijarah or Murabaha the bank has adopted a form of a matrix format to calculate CAR at any given time during the various stages where a borrower is servicing the loan. More so the bank risk changes from price risk to credit risk, a feature which must be incorporated in CAR calculations (Hassan 2004).
These features and other Islamic banking services such as profit-loss sharing and sukuk are not provided for in both of the Basel accords. Sukuk is the equivalent of what the universal banks refer as bonds, but which does not provide for fixed interest rates or indeed any form of interest at all (Hassan 2004). Basel I capital adequacy guidelines hardly factored in this peculiarities of the Islamic banking system, nevertheless the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) adjusted the CAR calculations to allow their applications by Islamic financial institutions (Timberg 2000). However Basel II new guidelines have provided for these adjustments to an extent, for instance the new guidelines expanded the form of risks that can be calculated to include credit risk, price/market risk therefore enabling Islamic banks to calculate CAR for Risk Weighted Assets (RWA).
Islamic banks are therefore able to calculate most forms of credit risks using standard approach method, but there are other cases where credit risk calculations do not apply such as in Musharaka and Mudaraba. In such cases the banks normally applies specialized lending guidelines that are outlined in Basel II such as the “supervisory slotting method” or the “equity position risk in banking book method” (Timberg 2000). Despite this, Islamic banks continue to face challenges and unique risks as well, for example the Sharia Compliance Risk (Timberg 2000). This is a form of risk faced only by Islamic banks which include financial losses encountered due to financial transactions that arise from non-recognition of specific sources of incomes or losses associated with compliance to the banking system.
Capital adequacy ratio is calculated by dividing the bank primary capital by the sum of the bank’s assets (Basel 2006). The core capital is a sum of both Tier I and II capital while assets in this case refers to the weighted assets or the minimum requirements as set by the banking regulator, such a ratio should not exceed the Basel accord threshold level that is set equal to or less than 8%. The CAR is further adjusted to calculate the three other subcomponents of the capital adequacy namely: standardized approach, basic indicator approach and advanced measurement approach that offer varying degree of accuracy (Basel 2006).
An integral component of current CAR calculation is the risk weighting of a bank’s assets which assigns a percentage figure for each category of assets based on the probability of credit risk that might occur for each category of the assets.
For this purpose the approach used in calculating risk weighting requires the bank to categorize the nature of the assets into two: fund based assets and non-funded assets (Basel 2006). Fund based assets usually include bank investments, loans and liquid cash at its disposal, while non-funded assets include items in the Off-Balance sheet that are first taken through a series of conversions in order to ascertain their true value. For instance government debt and bonds are usually assigned zero percentage on risk weight, mortgage loans attracts 50% risk weight and 100% for all other forms of loans advanced to borrowers (Basel 2006).
Further changes to the existing CAR calculation guidelines continues to be included in the Basel accords on capital adequacy, most recently in July 2009 which incorporated other factors in market risk and incremental risk calculations. This new modifications of capital adequacy calculations provides Islamic banks with basis for incorporating the unique features of their financial transactions, more importantly the Islamic Financial Services Board (IFSB) has played a major role in the way that Basel II has addressed the controversy that surrounds capital adequacy calculation and in lobbying for the concepts used by Islamic banks to be included in future Basel guidelines.
Case study: Jordan Islamic Bank for Finance and Development
During the start of the 1980 decade, the Islamic banking system underwent a revolution that is still ongoing up to this moment. This was a time when the OPEC countries had excess liquidity capital occasioned by oil revenues, however the catalysts that contributed to the rapid growth of Islamic banking can be attributed to both internal and external factors. During this period most Arab countries were experiencing financial challenges due to lack of strong financial institutions, hence this become one of the areas that most countries focused their policies. Besides this factor, the US dollar had become consistently strong against most of the currencies of the Arab countries partly due to high rate of capital flight that was caused by absence of solid financial institutions.
Jordan Islamic bank for Finance and Development (JIBFI) was one of the earliest type of Islamic bank to be established in Jordan, in fact it was the first in the country and was established in 1978 (Saleh and Zeitun 2006). However it was not until towards the end of the 1980s that JIBFI rapidly grew and become a significant player in the financial sector of the country. During the time when the bank was being established in 1978, the factors that facilitated it setup and operation was mainly because of the predominant Muslim population in the country which is high in a gulf countries. This same factor is the one that has continued to contribute to the JIBFI growth in the country where it is now one among the various Islamic banks that have since been established within the country.
During the years that JIBFI has been operational in Jordan, the bank has undergone and survived various transitions and challenges that have made it a model Islamic banking system at least in Jordan. It survived during it early years of operation when the government imposed mandatory regulations for financial institutions to increase their capital amount that were directly held by the government up to 8% while also significantly increasing the minimum operating capital (Saleh and Zeitun 2006). At this period the Jordan government financial policies were not guided by any Basel accord since the first Basel accord of 1988 was still being deliberated. Hence the government policy on capital reserve and banks operation would not have been aligned with the Basel capital adequacy, not for many years to come.
Since its inception JIBFI has always operated fully as an Islamic bank in compliant with all the Sharia law in all its financial transactions (Saleh and Zeitun 2006). Since it operated on the principle of PLS, the bank It financial operations have always involved investment of the depositors fund and shareholders capital in other companies in order to share profit. This arrangement could be very risky where no guidelines exist that can be used to calculate and determine the limit of depositors and stakeholders funds that the financial institution should commit to such ventures without exposing it to unnecessary risk. A look at the financial data of the bank for the period 1998 to 2003 indicates that the bank was consistently exposing itself to financial due to the high rate of lending that it was undertaking. Certainly, the bank would not have also met the minimum standards of lending as outlined in the current capital adequacy ratio of Basel II. In 2003 for example, the bank lending was at JD321.983 million against a total capital base of 975.490. The capital adequacy ratio of the bank was therefore at 33% way above the recommended CAR of 8%. The following table indicates the bank financial data that can be used to determine the CAR for specific years and the general trend of lending at the time which determine how well the JIBFI was in compliant to any of the Basel accords in terms of capital adequacy.
|Jordan Islamic Bank for Finance and Investment (JIBFI)|
|Direct Credit, Net||392||278||251||253||281||322|
|Total Shareholders’ Equity||51||53||55||54||56||57|
|Direct Credit, Net||-29||-9.5||0.6||11||14|
|Total Shareholders’ Equity||3.3||3.7||-1.7||3.6||2.5|
|Source: Central Bank of Jordan and Amman Stock Exchange, 2006*1|
In analysis of JIBFI financial data it is important to note that Islamic banks greatest risk is caused by the bank unique feature of Profit and Loss Sharing (PLS) system. It can be argued that the bank lending ideology that does not charge any interest rate to borrowers is form of an incitement that attracts dubious borrowers with no intention to repay the money. As a result Islamic banks are more likely to post high numbers of credit defaulters compared to other conventional banks. It is therefore necessary to institute precautionary measures that will act as a deterrent to potential defaulters.
Jordan is one of very few countries in the gulf region that has made strides towards aligning it financial regulation in line with Basel guidelines and therefore attain it vision of financial institutions that meet the international banking standards. Several reports from international oversight bodies such as IMF, Independent Evaluation Office (IEO) and Commission of European communities have so far confirmed this fact. Since 2005 Jordan has been implementing and designing other regulations that address the Basel Core Principles (BCP’s) and is on track to meeting most of the Basel I and II guidelines both in it conventional banks as well as in Islamic banks by year 2010 (eStandardforum 2009). For instance the Jordan CBJ has now increased focus on strengthening the regulatory mechanisms that would ensure banks are more closely supervised. The Central Bank of Jordan has also announced that it will gazette the capital requirements of financial institutions to be doubled; in addition it has put in place a system that will be used to monitor the financial sector and inform authorities of nonprocedural conduct well in advance.
So far CBJ has already implemented some of the framework as outlined by Basel I accord such as watertight and rigorous procedures for licensing financial institutions. It also undertakes regular bank supervisions in accordance with the concepts described in Basel I and is routinely involved in capacity building of financial institutions in partnership with other stakeholders such as IMF towards promoting the Basel financial sector standards in banks (eStandardforum 2009). So far it has enacted the Anti-Money Laundering act and another act for regulating credit is on the pipeline: the Credit Bureau. Currently Jordan is in the process of aligning its financial institutions to meet the guidelines of Basel II which require more oversight and stringent regulations.
History of the Basel committee and its Membership
Basel committee is a body that was found in 1974 in Basel, Switzerland with mandate to develop regulatory frameworks for financial institutions in the wake of international financial market shakeup that affected reputable bank institutions worldwide. On February 1975, the Basel committee convened for the first time and thereafter several times per year. It refers to the Committee on Banking Regulations and Supervisory Practices that was overseen by the ten Central-Bank governors of the various countries that had come together at the time to constitute it.
The founding member states of the Basel committee were compromised of Germany, France, Japan, Italy, Canada, Netherlands, Sweden, Spain, United Kingdom and United States and Luxembourg (Basel 2006). The first chairman of the Basel committee was Sir George Blunden from England who was at the time the central bank governor of the Bank of England, the chairmanship of the committee is on a rotating basis between the member countries (Basel 2001).
The general idea behind the formation of Basel committee was to provide a forum where member states can hammer out the modalities of cooperation on banking regulatory and oversight matters between themselves (Basel 2001). Besides this the committee had the mandate to align the various countries approach to financial practices worldwide. In order to achieve this vision the committee set out three approaches that would enable realization of this goal namely: facilitate key financial information on bank supervision, strengthen the banking supervisory tools for compliance purposes and finally develop minimum supervisory guidelines (Basel 2001). The committee has no legal objectives to enforce the Basel accords in any of the international financial institutions but rather rely on individual countries banking oversight authorities. It is this early concerns and tireless efforts of the committee that the comprehensiveness of the current Basel II guidelines on capital adequacy can be attributed. The countries and the financial institutions that have come to adopt the Basel Accord have grown from the founding member states to almost all countries that have decent financial institution. To date more than 140 countries are known to apply the minimum acceptable guidelines as outlined in the 1988 Basel Accord in regulating their financial institutions (Basel 2001). Also notable is the financial concept that Basel Accord has developed over the years which is now taught in classroom as internationally acceptable financial practices.
Objectives of the Basel committee
The first frameworks that Basel Accord advanced in 1988 on capital adequacy was limited to assisting the financial institutions address the credit risks that they faced. It was a form of crude calculation of capital adequacy in comparison to the current standards; it assumed factoring of bank credit risk will also consequently address other form of risks inherent in banking financial transactions, a fact that was only partly true (Basel 2001). The initial Basel Accord objectives that were developed in 1988 have hardly changed in anyway; however the current objectives have been redefined but remains in line with Basel I accord. The current objectives of Basel committee have four core roles that cover every major activity of the organization.
The first objective is “To Promote Safety and Soundness in the Financial System” (Basel 2001). This is one of the fundamental objectives of Basel Committee which the rest of the objectives revolve around; it is the foundation principle in which the committee was found. Indeed the reason the committee has gone to great lengths of defining the CAR calculation is based on the fact that capital adequacy is the single most determinant of the financial institution stability. The logic is that development of an effective approach of determining capital adequacy and it monitoring will cushion financial institutions from unforeseen risks that might result to their collapse besides ensuring that the banks remain stable. To this end the committees recently developed the most comprehensive guidelines so far for calculating capital adequacy.
The second objective pertains to the committee role in promoting equal competitive advantage for all financial institutions, in other words the committee strives to develop guidelines that do not provide some financial institutions with competitive edge or undue advantage (Basel 2001). The committee guidelines therefore act as a form of level playing field for international financial institutions. To compensate for the diverse intrinsic nature of the banking system that is caused by different legal and other requirements, the bank crafted the concept of the second and third pillar with this fact in mind. The third objective is the role of the Basel accord to be structured in a way that address all the possible risks associated with financial transactions that banks are exposed to.
This is the reason that Basel II incorporates all other known risks that were not previously considered in calculating CAR such as liquidity risk, systematic risk, price risk, displaced commercial risk and frugality risk. Finally the last objective of the accord is to structure the guidelines to accommodate local banks or other form of institutions such as Islamic banks and banking groups in a way that enable them to apply the guidelines in their financial operations. This way the Basel accord is able to be adopted by various financial institutions in risk management.
Fundamental aspects of the Basel convention
The fundamental concept of the Basel accord is contained in it three pillars which between themselves covers the entire concept of the frameworks. The first pillar is referred as Minimum Capital requirements, that has the mandate to provide banks with frameworks that determine the level at which it should retain capital at any given time (Scott 2005). In calculation of the desired minimum capital the bank must factor in three types of risks namely: credit risk, market risk and all other form of risks (Scott 2005). Credit Risk refers to risk associated with lending which is in other words the amount of loan advanced by a bank. All other risks are captured by the other two types of risks, that is the market risk also referred as price risk and “other risks”.
For each category of these risks the Basel accord has developed guidelines for it calculation. The second pillar is the Supervisory Review, it focus is on development of guidelines that supervisors must apply in determining the financial institutions compliance to the guidelines (Scott 2005) More often it is the financial institutions that have the need to use regulation guidelines to determine their level of compliance, beside the countries oversight authorities that has the mandate to enforce these regulations.
The last pillar is Market Discipline which is designed to provide the banks with incentives that ensure their cooperation in upholding best business practices and financial ethics (Scott 2005). This pillar recognizes that banks financial practices are tied together with the Basel framework and can ultimately determine the financial institution capital base, hence the need to have banks adopt them. In addition market discipline serves to promote equality of financial institutions since they require the banks to observe the same guidelines. The accord notes that financial institutions good reputations which is a product of market discipline is an important factor in contributing to it stability.
Decisions of Basel committee and regulatory amendments
The decisions of the Basel committee have always involved the way that it has outlined new guidelines over the years in order to respond to financial institutions challenges. In this part we are going to briefly assess how the Basel committee has undertaken amendments to the first accord of 1988 by evaluating the impact of new guidelines to the financial sector. The 1988 accord which outlined the first guidelines has various weaknesses as we have so far discussed in the previous chapters, besides that financial sector is very dynamic in nature and new frameworks must keep being updated in order for it to remain relevant: this are the two main reasons that saw the numerous changes to the accord that are still ongoing.
The tenets that Basel committee was found are better captured by the 1983 report titled “Principles for the Supervision of Banks’ Foreign Establishment” (Basel 2006). This was one of the earliest works of the committee which sought to address the two priority concerns at the time: to ensure that all financial institutions worldwide are regulated by the guideline set out in the document and also to ascertain the guidelines are adequate for the task. In 1990 the bank revised the 1983 report, referred as the concordant to include other broad ranges of information sharing between financial institutions. Two years later in 1992 the committee tabled the most comprehensive guidelines for regulating and supervising financial institutions, in a report dubbed Millennium Standards which was the foundation on which current regulations are based (Basel 2006).
However this guidelines of the committee have always been limited in terms of their applicability, hence the need to constantly keep updating the frameworks in order to reflect the most current trends in the financial sector and also to incorporate features that enhance the applicability of the document. In 1996 for example during the International Conference on Banking Supervisors (ICBS) the committee launched another report that addressed the challenges faced by financial institutions in implementing the Basel Guidelines and best approaches that countries and banks should implement in order to overcome this challenges. In recent years the focus of the Basel committee has gradually shifted to capital adequacy in order to address imminent risk that most bank institutions face worldwide. There is no doubt that the road that have led to this increased efforts in addressing the capital adequacy can be traced back to the early 80s when most financial institutions went bankrupt due to reasons associated with capital adequacy.
Fundamental Aspects of Basel II Convention and McDonough Percentage
The issues that we are going to tackle in this part of the essay are going to be two parts: the fundamental aspect of Basel II convention and McDonough concept as outlined in the accord. We are only going to briefly outline the fundamental aspect that are unique to Basel II since we have already covered much of it in earlier parts of this paper. The hallmark feature of Basel II convention is it comprehensive approach of calculating CAR by incorporating a variety of risk factors, most notable its ability to enable financial institutions to develop models that they can use to calculate their capital adequacy that are not covered by the existing guidelines.
Basel II guidelines address the range of issues that are necessary to ensure the most accurate CAR figure is attained. It therefore focuses on determination of risk weight for the particular financial institution list of assets, a feature that is unique to Basel II accord only (Basel 2000). Another integral feature of Basel II is the way that it approaches the issue of risk management by the banks: a form of a holistic approach that strives to have each level of financial institution adopts guidelines for the purpose of risk management.
Another feature emanates from the sophistication employed by Basel II in calculating the capital adequacy; in the process the accord has developed a form of an inbuilt system that prevents capital arbitrage by financial institutions (Basel 2000). This means it is now impossible for the banks to manipulate the various components of capital undetected and thereby expose shareholders and depositors assets to unnecessary risks. Last but not the least is the McDonough Ratio which is a characteristic feature of Basel II only (Basel 2000).
McDonough percentage is a ratio that was formed as a result of modifications done on Cooks ratio contained in Basel I, in the process not only did the elements of calculation change but the name as well (Schleifer and Vishny 1997). In a nut shell McDonough percentage is the process that is applied in calculating the capital adequacy of a financial institutions as outlined in Basel II, more specifically its unique feature is its calculation of risk weights for various assets. The concept behind risk-weights originates from the fact that various borrowers have various probabilities of defaults and therefore it factors in the associated risks appropriately. For instance government bonds are assigned a risk percentage of zero for reasons that a government is unlikely to default on a loan The components used in calculating McDonough ratio are generally core capitals and assets.
Pros and cons of the Basel committee
With the introduction of the Basel II regulatory frameworks most of the limitations that were posed by the earlier Basel I framework have been addressed, nevertheless other limitations in the present frameworks still persist. The fact that the financial sector is always rapidly evolving means that any form of regulatory guidelines defined by Basel committee shall always be limited in one way or another and must constantly therefore be kept updated, this is by far the single most shortcoming of the Basel II accord. Another weakness is the fact that Basel II Accord still fall shorts of embracing the few financial institutions that are not in the mainstream, notably the Islamic banks as we have already found out. This is disappointing given that one of the objectives of the Basel committee is to provide guidelines that can be applied by all forms of financial institutions.
Finally the Basel II accord encourages internal supervisory tools to be developed by the banks that are essentially different from what the supervisors would be applying in their assessment compliance, while this has some sort of advantages; this arrangement provides a hurdle that has been hard to overcome. This is because the internal regulatory system can utilize private data to arrive at more accurate figures but which they cannot divulge to a bank supervisor for the same purposes, a dilemma that is yet unresolved of whether to discourage the banks from using internal regulatory systems or not.
The advantage offered by Basel II accord are numerous but essentially the same, one of the most obvious advantage is the ability of the accord to offer financial institutions with an accurate assessment of their capital adequacy which translates to effective risk management. With the advanced calculations and comprehensiveness it will be difficult to enter into uninformed risky initiatives that are not quantifiable from the onset, in fact it will be impossible to contravene this guidelines in light of the supervisory review that are currently in place. The Basel II accords also overcome another challenge that Basel I guidelines were unable to address: the deterrent of financial institution to undertake capital arbitrage. The accord also went beyond its mandate and provided the banks with models for calculating other forms of unique risks that the bank could be exposed to but which are not addressed by the accord. A typical example is the Islamic bank capital adequacy calculation model that is essentially the Basel II accord but with modifications to address it unique features.
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- Central Bank of Jordan and Amman Stock Exchange 2006 cited in Saleh and Zeitun, 2006, p.4