4.1. General

(1) An Islamic Bank’s total Capital Resources are defined as the sum of its Tier 1 Capital and Tier 2 Capital. The categories and elements of regulatory Capital, and the limits, restrictions and adjustments to which they are subject are set out in this Chapter.

(2) Capital supports an Islamic Bank’s operation by providing a buffer to absorb unexpected losses from its activities and, in the event of problems, it enables an Islamic Bank to continue to operate in a sound and viable manner while the problems are resolved. Capital management must be an integral part of an Islamic Bank’s enterprise-wide risk management process and must align an Islamic Bank’s risk tolerance and risk profile with its capacity to absorb losses.

4.2. Application to branches

(1) This Chapter does not apply to an Islamic Bank that is operating as a branch insofar as this Chapter would require the branch to hold Capital Resources to meet Capital Requirements.

(2) A branch is required to comply with the reporting requirements under this Chapter.

4.3. Governing Body’s responsibilities

(1) An Islamic bank’s Governing Body must consider whether the Capital and liquidity requirements specified by these rules are adequate to ensure that there is no significant risk that an Islamic Bank’s liabilities cannot be met as they fall due. The Islamic Bank must obtain additional Capital or liquid assets if its Governing Body considers that the minimum requirements do not adequately reflect the risks of its business.

(2) The Governing Body is also responsible for:

• (a) ensuring that Capital management is part of an Islamic Bank’s overall risk management and is aligned with its risk tolerance and risk profile;
• (b) ensuring that the Islamic Bank has, at all times, Capital and liquid financial resources of the kinds and amounts required by these rules;
• (c) ensuring that the Islamic Bank has Capital, of adequate amount and appropriate quality, for the nature, scale and complexity of its business and for its risk profile;
• (d) ensuring that the amount of Capital Resources it has exceeds its minimum Capital Requirement;
• (e) approving the Islamic Bank’s ICAAP and any significant changes to it; and
• (f) monitoring the adequacy and appropriateness of the Islamic Bank’s systems and controls and the Islamic Bank’s compliance with them.

Guidance

(1) An Islamic bank’s risk management strategy will usually refer to risk tolerance although risk appetite may also be used. The terms ‘risk tolerance’ and ‘risk appetite’ embrace all relevant definitions used by different institutions and supervisory authorities. These 2 terms are used interchangeably to describe both the absolute risks a firm is open to take (which some may call risk appetite) and the actual limits within its risk appetite that a firm pursues (which some call risk tolerance).

(2) If an Islamic Bank is a member of a Financial Group, the AFSA expects the Capital of the Financial Group to be apportioned among the group’s members, based on the allocation of risks between them.

4.4. Systems and controls

(1) An Islamic Bank must have adequate systems and controls in place to enable it to calculate and monitor its minimum Capital requirement.

(2) The systems and controls must be documented in writing and must be appropriate for the nature, scale and complexity of its business and for its risk profile.

(3) The systems and controls must enable an Islamic Bank to demonstrate, at all times, whether it complies with this Chapter.

(4) The systems and controls must enable an Islamic Bank to manage available Capital in anticipation of events or changes in market conditions.

(5) The systems and controls must include ICAAP, and an Islamic Bank must have contingency arrangements to maintain or increase its Capital in times of stress.

4.5. Internal Capital Adequacy Assessment Process (ICAAP)

(1) An Islamic Bank’s Internal Capital Adequacy Assessment Process or ICAAP is the process by which an Islamic Bank continuously demonstrates that it has implemented methods and procedures to ensure that it has adequate Capital resources to support the nature and level of its risks.

(2) An Islamic bank’s ICAAP (and any significant changes to it) must be documented in writing and must have been approved by an Islamic Bank’s Governing Body. A copy of the ICAAP must be given to the AFSA on request.

(3) An ICAAP must reflect the nature, scale and complexity of an Islamic Bank’s operations and must include:

• (a) adequate policies and staff to continuously identify, measure, evaluate, manage and control or mitigate the risks arising from its activities, and monitor the Capital held against such risks;
• (b) a strategy for ensuring that adequate Capital is maintained over time, including specific Capital targets set out in the context of its risk tolerance, risk profile and Capital requirements;
• (c) plans for how Capital targets are to be met and the means available for obtaining additional Capital, if required;
• (d) procedures for monitoring its compliance with its Capital requirements and Capital targets;
• (e) triggers to alert senior management to, and specified actions to avert and rectify, possible breaches of Capital requirements;
• (f) procedures for reporting on the ICAAP and its outcomes to an Islamic Bank’s Governing bBody and senior management, and for ensuring that the ICAAP is taken into account in making business decisions;
• (g) policies about the effect on Capital of significant risks not covered by explicit Capital requirements;
• (h) triggers, scope and procedures for reviewing the ICAAP and in the light of changed conditions and factors affecting an Islamic Bank’s risk tolerance, risk profile and Capital;
• (i) procedures for reporting the results of reviews;
• (j) an adequate recovery plan for restoring an Islamic Bank’s financial situation after a significant deterioration; and
• (k) procedures for stress-testing and the review of stress scenarios.

(4) An Islamic Bank’s ICAAP must be reviewed by an appropriately qualified person at least once every 3 years. The person must be independent of the conduct of an Islamic Bank’s Capital management.

4.6. Initial and ongoing Capital requirements

(1) An Islamic Bank is expected to meet minimum risk-based Capital requirements for exposure to credit risk, market risk and operational risk. An Islamic Bank’s Capital adequacy ratios (consisting of CET 1 ratio, Tier 1 Capital ratio and Total Capital ratio), calculated by dividing relevant levels of its Regulatory Capital by total Risk-Weighted Assets.

(2) Total Risk-Weighted Assets of an Islamic Bank is the sum of:

• (a) an Islamic Bank’s credit risk-weighted on-balance-sheet and off-balance-sheet items calculated in accordance with chapter 6 of this Rules; and
• (b) 12.5 times the sum of an Islamic Bank’s market and operational risk Capital requirements (to the extent that each of those requirements applies to an Islamic Bank).

4.7. Base Capital requirement

The Base Capital Requirement is defined as:

• (a) for an Islamic Bank— USD 10 million;
• (b) for an Islamic Broker Dealer— USD 2 million; and
• (c) for an Islamic Financing Company – USD 2 million.

4.8. Required Tier 1 Capital on authorisation

(1) An entity must have, at the time of its authorisation and at all times thereafter, CET 1 Capital of at least equal to its Base Capital Requirement, defined in Rule 4.7 above.

(2) The AFSA will not grant an authorisation unless it is satisfied that the entity complies with this requirement.

4.9. Required ongoing Capital

(1) An Islamic Bank must have, at all times, Regulatory Capital which exceeds the amount of its Capital Requirement.

(2) The Capital Requirement for an Islamic Bank is determined as the higher of the two amounts set out below:

• (a) the applicable Base Capital Requirement as set out in Rule 4.7; or
• (b) its Risk Capital Requirement as set out in Rule 4.10.

(3) In case of an Islamic Bank whose Capital Requirement is determined by Risk Capital Requirement, and the AFSA has imposed additional capital requirements imposed on it, then the Capital Requirement applicable to it is determined as the sum of such additional capital requirements imposed by the AFSA and its Risk Capital Requirement.

Guidance

(1) An Islamic Bank whose minimum Capital requirement is its risk-based Capital requirement is subject to the additional requirement to maintain a Capital Conservation Buffer—see rule 5.2.

(2) The minimum amount of Regulatory Capital that a firm must have at all times is its Capital Requirement.

4.10. Risk Capital requirement

The Risk Capital requirement for an Islamic Bank is calculated as the sum of:

• (a) its credit risk Capital requirement;
• (b) its market risk Capital requirement; and
• (c) its operational risk Capital requirement.

4.11. Capital adequacy ratios

(1) An Islamic bank’s Capital adequacy is measured in terms of 3 Capital ratios expressed as percentages of its total Risk-Weighted Assets (RWA).

(2) An Islamic Bank must maintain at all times, the following Capital adequacy ratios, at a minimum level of:

• (a) 4.5% of RWA for CET 1 Capital ratio;
• (b) 6% of RWA for Tier 1 Capital ratio; and
• (c) 8% of RWA for Total Capital ratio.

(3) The AFSA may, if it believes it is prudent to do so, increase any or all of a firm’s minimum Capital adequacy ratios. The AFSA will notify an Islamic Bank in writing about a new Capital adequacy ratio and the timeframe for meeting it.

(4) An Islamic Bank must maintain, at all times, Capital adequacy ratios higher than the required minimum levels specified in Rule 4.11 (2) above, so that adequate Capital is maintained in the context of the Islamic Bank’s risk tolerance, risk profile and Capital requirements, and as an additional buffer to absorb losses and preclude any potential breach of Capital adequacy rules. These higher ratios are the Islamic Bank’s risk-based Capital adequacy ratios.

4.12. Elements of regulatory Capital

(1) The Regulatory Capital of an Islamic Bank is the sum of its Tier 1 Capital and Tier 2 Capital.

(2) Tier 1 Capital is the sum of an Islamic Bank’s CET 1 Capital and Additional Tier 1 Capital. Tier 1 Capital is also known as going concern Capital because it is meant to absorb losses while an Islamic Bank is viable.

(3) Tier 2 Capital is the sum of the elements set out in Rule 4.17. Tier 2 Capital is also known as gone-concern Capital because it is meant to absorb losses after an Islamic Bank ceases to be viable.

(4) For these rules, the 3 categories of Regulatory Capital are CET 1 Capital, additional Tier 1 Capital and Tier 2 Capital.

Guidance Funds collected or forming part of PSIAs managed by an Islamic Bank do not form part of its

Regulatory Capital, because they do not satisfy the criteria for inclusion as either CET 1, Additional Tier 1 or Tier 2 Capital. Neither are the PER and IRR part of the Regulatory Capital of the Islamic Bank.

4.13. Common Equity Tier 1 Capital

Common Equity Tier 1 Capital (or CET 1 Capital) is the sum of the following elements:

• (a) common shares, issued by an Islamic Bank, that satisfy the criteria in Rule 4.14 for classification as common shares (or the equivalent for non-joint stock companies);
• (b) share premium (also known as stock surplus) resulting from the issue of instruments included in CET 1 Capital;
• (c) retained earnings;
• (d) accumulated other comprehensive income and other disclosed reserves;
• (e) common shares, issued by a consolidated subsidiary of an Islamic Bank and held by third parties, that satisfy the criteria in rule 4.23 for inclusion in CET 1 Capital;
• (f) regulatory adjustments applied in the calculation of CET 1 Capital in accordance with Rule 4.30.

Guidance

Retained earnings and other comprehensive income include appropriated profit or loss. Even though they are called reserves, the PER and IRR are not part of Tier 1 Capital of an Islamic bank. They are part of the equity of PSIA investors and, as such, do not have the requisite loss absorbency.

4.14. Criteria for classification as common shares

(1) An instrument issued by an Islamic Bank is classified as a common share and included in CET 1 Capital if all of the criteria in parts (2) to (15) of this Rule are satisfied.

(2) The instrument is the most subordinated claim in case of the liquidation of an Islamic Bank.

(3) The holder of the instrument is entitled to a claim on the residual assets that is proportional to its share of issued Capital, after all senior claims have been repaid in liquidation. The claim must be unlimited and variable and must be neither fixed nor capped.

(4) The principal amount of the instrument is perpetual and never repayable except in liquidation. Discretionary repurchases and other discretionary means of reducing Capital allowed by law do not constitute repayment.

(5) An Islamic Bank does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled. The statutory or contractual terms do not provide anything that might give rise to such an expectation.

(6) Distributions are paid out of distributable items of an Islamic Bank (including retained earnings) and the amount of distributions:

• (a) is not tied or linked to the amount paid in at issuance; and
• (b) is not subject to a contractual cap (except to the extent that a firm may not pay distributions that exceed the amount of its distributable items).

(7) There are no circumstances under which the distributions are obligatory. Non-payment of distributions do not constitute default.

(8) Distributions are paid only after all legal and contractual obligations have been met and payments on more senior Capital instruments have been made. There are no preferential distributions and in particular none for any other elements classified as the highest quality issued Capital.

(9) It is the issued Capital that takes the first and proportionately greatest share of any losses as they occur. Within the highest quality Capital, each instrument absorbs losses on a going-concern basis proportionately and equally with all the others.

(10) The paid-in amount is recognised as equity Capital (rather than as a liability) for determining balance-sheet insolvency.

(11) The paid-in amount is classified as equity in accordance with the relevant accounting standards.

(12) The instrument is directly issued and paid-in, and an Islamic Bank has not directly or indirectly funded the purchase of the instrument.

(13) The paid-in amount is neither secured nor covered by a guarantee of an Islamic Bank or a related party, nor subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim in relation to the claims of an Islamic Bank’s creditors.

(14) The instrument is issued only with the approval of the owners of an Islamic Bank, either given directly by the owners or, if permitted by the applicable law, given by its governing body or by other persons authorised by the owners.

(15) The instrument is clearly and separately disclosed on an Islamic Bank’s balance sheet. Guidance This criterion is taken to be satisfied even if the instrument includes a permanent write-down mechanism.

4.15. Additional Tier 1 Capital

Additional Tier 1 Capital is the sum of the following elements:

• (a) instruments, issued by an Islamic Bank, that satisfy the criteria in rule 4.16 for inclusion in Additional Tier 1 Capital (and are not included in CET 1 Capital);
• (b) share premium (also known as stock surplus) resulting from the issue of instruments included in Additional Tier 1 Capital;
• (c) instruments, issued by consolidated subsidiaries of an Islamic Bank and held by third parties, that satisfy the criteria in rule 4.24 for inclusion in Additional Tier 1 Capital (and are not included in CET 1 Capital);
• (d) regulatory adjustments applied in the calculation of Additional Tier 1 Capital in accordance with Rules specified later in this chapter.

4.16. Criteria for inclusion in Additional Tier 1 Capital

(1) An instrument issued by an Islamic Bank is included in Additional Tier 1 Capital if all of the criteria in parts (2) to (16) of this Rule are satisfied.

(2) The instrument must be structured using unrestricted non-exchange-based contracts (such as musharakah) and must comply with other Shari’ah requirements.

(3) The instrument is paid-in.

(4) The instrument is the most subordinated claim after those of depositors, general creditors and holders of the subordinated debt of an Islamic Bank.

(5) The paid-in amount is neither secured nor covered by a guarantee of an Islamic Bank or a related party, nor subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim in relation to the claims of an Islamic Bank’s creditors.

(6) The instrument is perpetual. It has no maturity date and there are no step-ups or other incentives to redeem.

(7) If the instrument is callable by an Islamic Bank, it can only be called 5 years or more after the instrument is paid-in and only with the approval of the AFSA. An Islamic Bank must not do anything to create an expectation that the exercise of the option will be approved, and, if the exercise is approved, an Islamic Bank:

• (a) must replace the called instrument with Capital of the same or better quality and at conditions sustainable for the income capacity of an Islamic Bank; or
• (b) must demonstrate to the AFSA that its Capital will significantly exceed an Islamic Bank’s minimum Capital requirement after the option is exercised.

(8) A repayment of principal through repurchase, redemption or other means must be approved by the AFSA. An Islamic Bank must not assume, or create a market expectation, that such approval will be given.

(9) The instrument must provide for an Islamic Bank to have, at all times, discretion not to make a distribution or pay a dividend. The exercise of the discretion must not impose restrictions on an Islamic Bank (except in relation to distributions to common shareholders) and must not constitute default.

(10) Dividends and profits must be paid out of distributable items.

(11) The instrument must not have a credit-sensitive-dividend feature under which a dividend or profit is periodically reset based (wholly or partly) on an Islamic Bank’s credit standing.

(12) The instrument must not contribute to an Islamic Bank’s liabilities exceeding its assets if such a balance-sheet test forms part of any insolvency law applying in the jurisdiction where the instrument was issued.

(13) An instrument classified as a liability for accounting purposes must have principal loss absorption through conversion to common shares, or a write-down mechanism that allocates losses to the instrument, at a pre-specified trigger point. The conversion must be made in accordance with Rule 4.20.

(14) Neither an Islamic Bank nor a related party over which an Islamic Bank exercises control has purchased the instrument, nor has an Islamic Bank directly or indirectly funded the purchase of the instrument.

(15) The instrument has no features that hinder re-capitalisation. For example, it must not require an Islamic Bank to compensate investors if a new instrument is issued at a lower price during a specified period.

(16) If the instrument is not issued out of an operating entity (such as a special purpose vehicle (or SPV)) or the holding company in the group of which an Islamic Bank is a member, the proceeds are immediately available without limitation to an operating entity or the holding company through an instrument that satisfies the other criteria for inclusion in additional Tier 1 Capital.

4.17. Tier 2 Capital

Tier 2 Capital is the sum of the following elements:

• (a) instruments, issued by an Islamic Bank, that satisfy the criteria in rule 4.18 for inclusion in Tier 2 Capital (and are not included in Tier 1 Capital);
• (b) share premium (also known as stock surplus) resulting from the issue of instruments included in Tier 2 Capital;
• (c) instruments, issued by consolidated subsidiaries of an Islamic Bank and held by third parties, that satisfy the criteria in Rule 4.25 for inclusion in Tier 2 Capital (and are not included in Tier 1 Capital);
• (d) regulatory adjustments applied in the calculation of Tier 2 Capital in accordance with Rules specified later in this chapter;
• (e) general provisions or general reserves held against future, presently unidentified losses (but only up to a maximum of 1.25% of risk weighted assets for credit risk, calculated using the standardised approach). Guidance

(1) General provisions and reserves are freely available to meet losses that subsequently materialise and therefore qualify for inclusion in Tier 2 Capital. In contrast, provisions for identified deterioration of particular assets or known liabilities, whether individual or grouped, should be excluded because they would not be available to meet losses.

(2) Even though they are called reserves, the PER and IRR are not part of Tier 2 Capital of an Islamic bank. They are part of the equity of PSIA investors and, as such, do not have the requisite loss absorbency.

4.18. Criteria for inclusion in Tier 2 Capital

(1) An instrument issued by an Islamic Bank is included in Tier 2 Capital if all the criteria in sub-rules (2) to (11) are satisfied.

(2) The instrument is paid-in.

(3) The instrument is the most subordinated claim after those of depositors, general creditors and holders of the subordinated debt of an Islamic Bank.

(4) The paid-in amount is neither secured nor covered by a guarantee of an Islamic Bank or a related party, nor subject to any other arrangement that legally or economically enhances the seniority of the holder’s claim in relation to the claims of an Islamic Bank’s depositors and general creditors.

(5) The original maturity of the instrument is at least 5 years.

(6) The recognition in Regulatory Capital in the remaining 5 years before maturity is amortised on a straight line basis and there are no step-ups or other incentives to redeem.

(7) If the instrument is callable by an Islamic Bank, it can only be called 5 years or more after the instrument is paid-in and only with the approval of the AFSA. An Islamic Bank must not do anything to create an expectation that the exercise of the option will be approved, and, if the exercise is approved, an Islamic Bank:

• (a) must replace the called instrument with Capital of the same or better quality and at conditions sustainable for the income-generating capacity of an Islamic Bank; or
• (b) must demonstrate to the AFSA that its Capital will exceed an Islamic Bank’s minimum Capital requirement after the option is exercised.

(8) The holder has no right to accelerate future scheduled payments of profit or principal, except in bankruptcy or liquidation.

(9) The instrument does not have a credit-sensitive-dividend feature under which a dividendor profit is periodically reset based (wholly or partly) on an Islamic Bank’s credit standing.

(10) Neither an Islamic Bank nor a related party over which an Islamic Bank exercises control has purchased the instrument, nor has an Islamic Bank directly or indirectly funded the purchase of the instrument.

(11) If the instrument is not issued out of an operating entity (such as an SPV) or the holding company in the group of which an Islamic Bank is a member, the proceeds are immediately available without limitation to an operating entity or the holding company through an instrument that satisfies the other criteria for inclusion in Tier 2 Capital.

4.19. Mudarabah sukuk or wakalah sukuk as Tier 2 Capital

(1) Subject to compliance with Shari’ah, an Islamic Bank may issue Mudarabah Sukuk or Wakalah Sukuk that qualify for inclusion in Tier 2 Capital under rule 4.20. For the sukuk, the underlying assets are convertible to common equity at the point of non-viability.

(2) The sukuk contract must state the terms of conversion, trigger point and conversion ratio. The conversion must be made in accordance with Rule 4.20.

4.20. Requirements—loss absorption at point of non-viability

(1) This rule applies to an Additional Tier 1 or Tier 2 instrument issued by an Islamic bank. It sets out additional requirements to ensure loss absorption at the point of non-viability.

(2) The terms and conditions of an instrument must give the AFSA the discretion to direct that the instrument be written-off or converted to common equity on the occurrence of a trigger event.

(3) An Islamic Bank must be able to issue the required number of shares specified in the instrument if a trigger event happens. The issuance of any new shares because of a trigger event must happen before any public sector injection of Capital so that Capital provided by the public sector is not diluted.

(4) Trigger event, in relation to an Islamic Bank that issued the instrument, is the earliest of:

• (a) a decision of the AFSA that a write-off (without which an Islamic Bank would become non-viable) is necessary; and
• (b) a decision by the relevant authority in AIFC to make a public sector injection of Capital, or give equivalent support (without which injection or support an Islamic Bank would become non-viable, as determined by that authority).

(5) If an Islamic Bank is a member of a Financial Group and an Islamic Bank wishes the instrument to be included in the Group’s Capital in addition to its solo Capital, the trigger event must be the earliest of:

• (c) the decision in part (4) (a) of this Rule 4.20;
• (d) the decision in part (4) (b) of this Rule 4.20;
• (e) a decision, by the relevant authority in the parent’s home jurisdiction, that a writeoff (without which an Islamic Bank would become non-viable) is necessary; and
• (f) a decision, by the relevant authority in the jurisdiction of the financial regulator that regulates any parent of the Islamic Bank, to make a public sector injection of Capital, or give equivalent support, in that jurisdiction (without which injection or support an Islamic Bank would become non-viable, as determined by that authority).

(6) Any compensation paid to the holder of an instrument because of a write-off must be paid immediately in the form of common shares (or the equivalent for non-joint-stock companies).

(7) If an Islamic Bank is a member of a Financial Group, any common shares paid as compensation to the holder of the instrument must be common shares of an Islamic Bank or of the parent entity of the group.

Guidance

Conversion or write-off under this rule would be limited to the extent necessary to enable the AFSA to conclude that an Islamic Bank is viable without further conversion or write-off.

4.21. Requirements for writing-off

(1) For an instrument that is to be written-off under Rule 4.20:

• (a) the write-off must reduce:
• (i) the claim of the instrument in liquidation;
• (ii) the amount repaid when a call option is exercised; and
• (iii) dividend or profit payments on the instrument;
• (b) the write-off must be permanent;
• (c) the provisions governing the issuance of the instrument must specify that a writeoff does not constitute default or trigger cross-default clauses; and
• (d) the write-off must generate CET 1 Capital under the relevant accounting standards and the instrument will only receive recognition in Tier 2 Capital up to the minimum level of CET 1 Capital generated by a full write-off of the instrument.

(2) The write-off of an instrument using a murabahah contract must be through the investor (as creditor):

• (a) making a promise (wa’ad) to waive rights on debts at the point of non-viability; or
• (b) agreeing, in the relevant legal documents, to waive rights on debts at the point of non-viability.

(3) The write-off of an instrument using an ijarah contract must be through the investor (as lessor):

• (a) making a promise (wa’ad) to transfer ownership of the underlying asset (beneficial or otherwise) to the lessee without consideration; or
• (b) agreeing, in the relevant legal documents, to waive rights on accrued rental at the point of non-viability.

(4) An Islamic Bank may apply to the AFSA for approval to use a write-off mechanism other than those in sub-rules (2) and (3) above.

4.22. Inclusion of third parties’ interests

This Section of Chapter 4 sets out the criteria and formulae for the inclusion, in an Islamic bank’s Regulatory Capital, of interests held by third parties.

4.23. Criteria for third party interests—Common Equity Tier 1 Capital

(1) For Rule 4.13, a common share, issued by a consolidated subsidiary of an Islamic Bank and held by a third party as a non-controlling interest, may be included in the Islamic Bank’s CET 1 Capital if:

(a) the share would be included in the Islamic Bank’s CET 1 Capital had it been issued by the Islamic Bank itself; and

(b) the subsidiary that issued the share is itself an Islamic bank or Islamic Broker Dealer (or an equivalent entity in its home jurisdiction).

(2) The amount to be included in the consolidated CET 1 Capital of an Islamic Bank is calculated in accordance with the following formula: NCI – ((CET1s – Min) × SS) where: NCI is the total of the non-controlling interests of third parties in a consolidated subsidiary of an Islamic Bank. CET1s is the amount of CET 1 Capital of the subsidiary.

Min is the lower of:

(a) 1.07 × (minimum CET 1 Capital requirement of the subsidiary); and

(b) 1.07 × (the part of the consolidated minimum CET 1 Capital requirement that relates to the subsidiary). SS means the percentage of the shares in the subsidiary (being shares included in CET 1 Capital) held by those third parties.

4.24. Criteria for third party interests—Additional Tier 1 Capital

(1) For Rule 4.15 (c ), an instrument (including a common share) issued by a consolidated subsidiary of an Islamic Bank and held by a third party as a non-controlling interest may be included in an Islamic Bank’s additional Tier 1 Capital if the instrument would be included in an Islamic Bank’s additional Tier 1 Capital had it been issued by an Islamic Bank.

(2) Any amount already included in CET 1 Capital must not be included in Additional Tier 1 Capital.

(3) The amount to be included in the consolidated Additional Tier 1 Capital of an Islamic Bank is calculated in accordance with the following formula:

NCI – ((T1s – Min) × SS)

where:

NCI is the total of the non-controlling interests of third parties in a consolidated subsidiary of an Islamic Bank.

T1s is the amount of Additional Tier 1 Capital of the subsidiary.

Min is the lower of:

(a) 1.07 × (minimum Additional Tier 1 Capital requirement of the subsidiary); and

(b) 1.07 × (the part of the consolidated minimum Additional Tier 1 Capital requirement that relates to the subsidiary). SS means the percentage of the shares in the subsidiary (being shares included in Additional Tier 1 Capital) held by those third parties.

4.25. Criteria for third party interests—Tier 2 Capital

(1) For rule 4.17 (c), an instrument (including a common share and any other Tier 1 Capital instrument) issued by a consolidated subsidiary of an Islamic Bank and held by a third party as a non-controlling interest may be included in the Islamic Bank’s Tier 2 Capital if the instrument would be included in the Islamic Bank’s Tier 2 Capital had it been issued by the Islamic Bank.

(2) Any amount already included in CET 1 Capital or Additional Tier 1 Capital must not be included in Tier 2 Capital.

(3) The amount to be included in the consolidated Tier 2 Capital of an Islamic Bank is calculated in accordance with the following formula:

NCI – ((T2s – Min) × SS)

where:

NCI is the total of the non-controlling interests of third parties in a consolidated subsidiary of an Islamic Bank.

T2s is the amount of Tier 2 Capital of the subsidiary.

Min is the lower of:

(a) 1.07 × (minimum Tier 2 Capital requirement of the subsidiary); and

(b) 1.07 × (the part of the consolidated minimum Tier 2 Capital requirement that relates to the subsidiary). SS means the percentage of the shares in the subsidiary (being shares included in Tier 2 Capital) held by those third parties.

4.26. Treatment of third party interests from SPVs

(1) An instrument issued out of an SPV and held by a third party must not be included in an Islamic Bank’s CET 1 Capital. Such an instrument may be included in an Islamic Bank’s Additional Tier 1 or Tier 2 Capital (and treated as if it had been issued by an Islamic Bank itself directly to the third party) if:

(a) the instrument satisfies the criteria for inclusion in the relevant category of Regulatory Capital; and

• (b) the only asset of the SPV is its investment in the Capital of an Islamic Bank and that investment satisfies the criterion in rule 4.16 or 4.18 for the immediate availability of the proceeds.

2) An instrument described in part (1) of this Rule that is issued out of a SPV through a consolidated subsidiary of an Islamic Bank may be included in an Islamic Bank’s consolidated Additional Tier 1 or Tier 2 Capital if the instrument satisfies the criteria in rule 4.16 or 4.18, as the case requires. Such an instrument is treated as if it had been issued by the subsidiary itself directly to the third party.

4.27. Regulatory adjustments

(1) Regulatory adjustments to an Islamic bank’s Capital may be required to avoid doublecounting, or artificial inflation, of its Capital. They may also be required in relation to assets that cannot readily be converted into cash.

(2) Adjustments can be made to all 3 categories of Regulatory Capital, but most of them are to CET 1 Capital.

4.28. Approaches to valuation and adjustment

(1) An Islamic Bank must use the same approach for valuing regulatory adjustments to its Capital as it does for balance-sheet valuations. An item that is deducted from Capital must be valued in the same way as it would be for inclusion in an Islamic Bank’s balance sheet.

(2) An Islamic Bank must use the corresponding deduction approach and the threshold deduction rule in making adjustments to its Capital.

4.29. Definitions

Entity concerned means:

• (a) a financial entity (including an Islamic Bank and a takaful entity); or
• (b) any other entity over which, under the relevant accounting standards, an Islamic Bank can exercise control.

Significant investment, by an Islamic Bank in an entity concerned, means an investment of 10% or more in the common shares, or other instruments that qualify as Capital, of the entity concerned. Investment includes a direct, indirect and synthetic holding of Capital instruments.

Guidance

(1) The notion of exercising control in this chapter is different from that in the definition of exercise control in the glossary. The term as defined in the glossary is used in relation to related parties and connected parties as they relate to credit risk, concentration risk and large exposures.

(2) The relevant accounting standards referred to (primarily AAOIFI and IFRS) use control in a much broader sense, so that an investor should consider all relevant facts and circumstances in assessing whether it controls an investee.

(3) Under IFRS 10, for example, an investor controls an investee if the investor has all of the following:

(i) power over the investee (that is, the investor has existing rights that give it the ability to direct the activities that significantly affect the investee’s returns)

• (ii) exposure, or rights, to variable returns from its involvement with the investee
• (iii) ability to use its power over the investee to affect the amount of the investor’s returns.

(4) Another example would be control through agreement with the entity’s other shareholders or with the entity itself. The agreement could result in control even if the investor holds less than majority voting rights, so long as those rights are substantive (that is, exercisable by the investor who has the practical ability to exercise them when relevant decisions are required to be made).

4.30. Adjustments to Common Equity Tier 1 Capital

Adjustments to CET 1 Capital must be made in accordance with the Rules specified in the following Rules 4.31 to 4.45. Regulatory adjustments are generally in the form of deductions, but they may also be in the form of recognition or de-recognition of items in the calculation of an Islamic Bank’s Capital.

4.31. Goodwill and intangible assets

An Islamic Bank must deduct from CET 1 Capital the amount of its goodwill and other intangible assets (except mortgage servicing rights). The amount must be net of any related deferred tax liability that would be extinguished if the goodwill or assets become impaired or derecognised under the relevant accounting standards.

4.32. Deferred tax assets

(1) An Islamic Bank must deduct from CET 1 Capital the amount of deferred tax assets (except those that relate to temporary differences) that depend on the future profitability of an Islamic Bank.

(2) A deferred tax asset may be netted with a deferred tax liability only if the asset and liability relate to taxes levied by the same taxation authority and offsetting is explicitly permitted by that authority. A deferred tax liability must not be used for netting if it has already been netted against a deduction of goodwill, other intangible assets or defined benefit pension assets.

Guidance

Any deferred tax liability that may be netted must be allocated pro rata between deferred tax assets under this rule and those under the threshold deduction rule. For the treatment of deferred tax assets that relate to temporary differences (for example, allowance for credit losses).

4.33. Cash flow hedge reserve

In the calculation of CET 1 Capital, an Islamic Bank must derecognise the amount of the cash flow hedge reserve that relates to the hedging of items that are not fair-valued on the balance sheet (including projected cash flows).

4.34. Cumulative gains and losses from changes to own credit risk

In the calculation of CET 1 Capital, an Islamic Bank must derecognise all unrealised gains and unrealised losses that have resulted from changes in the fair value of liabilities that are due to changes in an Islamic Bank’s own credit risk.

4.35. Defined benefit pension fund assets

(1) An Islamic Bank must deduct from CET 1 Capital the amount of a defined benefit pension fund that is an asset on an Islamic Bank’s balance sheet. The amount must be net of any related deferred tax liability that would be extinguished if the asset becomes impaired or derecognised under the relevant accounting standards.

(2) An Islamic Bank may apply to the AFSA for approval to offset from the deduction any asset in the defined benefit pension fund to which an Islamic Bank has unrestricted and unfettered access. Such an asset must be assigned the risk-weight that would be assigned if it were owned directly by an Islamic Bank.

4.36. Securitisation gains on sale

In the calculation of CET 1 Capital, an Islamic Bank must derecognise any increase in Equity Capital or CET 1 Capital from a securitisation or re-securitisation transaction (for example, an increase associated with expected future margin income resulting in a gain-on-sale).

4.37. Assets lodged or pledged to secure liabilities

(1) An Islamic Bank must deduct from CET 1 Capital the amount of any assets lodged or pledged by it, if:

• (a) the assets were lodged or pledged to secure liabilities incurred by the Islamic Bank;

and

• (b) the assets are not available to meet the liabilities of the Islamic Bank.

(2) The AFSA may determine that, in the circumstances, the amount of assets lodged or pledged need not be deducted from an Islamic Bank’s CET 1 Capital.

4.38. Acknowledgments of debt

(1) An Islamic Bank must deduct from CET 1 Capital the net present value of an acknowledgement of debt outstanding issued by it to directly or indirectly fund instruments that qualify as CET 1 Capital.

(2) This rule does not apply if the acknowledgement is subordinated in rank similar to that of instruments that qualify as CET 1 Capital.

4.39. Accumulated losses

An Islamic Bank must deduct from its CET 1 Capital the amount of any accumulated losses.

4.40. Deductions from categories of Regulatory Capital

(1) The deductions that must be made from CET 1 Capital, Additional Tier 1 Capital or Tier 2 Capital under the corresponding deduction approach are set out in this section of IBB Rules. An Islamic Bank must examine its holdings of index securities and any underlying holdings of Capital to determine whether any deductions are required as a result of such indirect holdings.

(2) Deductions must be made from the same category for which the Capital would qualify if it were issued by the Islamic Bank itself or, if there is not enough Capital at that category, from the next higher category.

(3) The corresponding deduction approach applies regardless of whether the positions or exposures are held in the banking book or trading book.

(4) If the amount of Tier 2 Capital is insufficient to cover the amount of deductions from that category, the shortfall must be deducted from additional Tier 1 Capital and, if additional Tier 1 Capital is still insufficient, the remaining amount must be deducted from CET 1 Capital.

4.41. Investments in own shares and Capital instruments

(1) An Islamic Bank must deduct direct or indirect investments in its own common shares or own Capital instruments (except those that have been derecognised under the relevant accounting standards). The Islamic Bank must also deduct any of its own common shares or instruments that it is contractually obliged to purchase.

(2) The gross long positions may be deducted net of short positions in the same underlying exposure only if the short positions involve no counterparty risk. However, gross long positions in its own shares resulting from holdings of index securities may be netted against short positions in its own shares resulting from short positions in the same underlying index, even if those short positions involve counterparty risk.

4.42. Reciprocal cross holdings

An Islamic Bank must deduct reciprocal cross holdings in shares, or other instruments that qualify as Capital, of an entity concerned.

4.43. Non-significant investments—aggregate is less than 10% of firm’s Common Equity Tier 1 Capital

(1) This rule applies if:

• (a) an Islamic Bank makes a non-significant investment in an entity concerned;
• (b) the entity concerned is an unconsolidated entity (that is, the entity is not included in an Islamic Bank’s consolidated returns);
• (c) an Islamic Bank does not own 10% or more of the common shares of the entity concerned; and
• (d) after applying all other regulatory adjustments, the total of the deductions required to be made under this rule is less than 10% of an Islamic Bank’s CET 1 Capital.

(2) An Islamic Bank must deduct any investments in common shares, or other instruments that qualify as Capital, of an entity concerned.

(3) The amount to be deducted is the net long position (that is, the gross long position net of short positions in the same underlying exposure if the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least 1 year).

(4) Underwriting positions held for more than 5 business days must also be deducted.

(5) If a Capital instrument is required to be deducted and it is not possible to determine whether it should be deducted from CET 1 Capital, Additional Tier 1 Capital or Tier 2 Capital, the deduction must be made from CET 1 Capital.

4.44. Non-significant investments—aggregate is 10% or more of firm’s Common Equity Tier 1 Capital

(1) This rule applies if, after applying all other regulatory adjustments, the total of the deductions required to be made under rule 4.43 is 10% or more of an Islamic Bank’s CET 1 Capital.

(2) An Islamic Bank must deduct the amount by which the total of the deductions required to be made under rule 4.43 exceeds 10% of an Islamic Bank’s CET 1 Capital. This amount to be deducted is referred to as the excess.

(3) The excess to be deducted from each category of Regulatory Capital under the corresponding deduction approach is calculated in accordance with the following formula:

where:

A is the amount of CET 1 Capital, additional Tier 1 Capital or Tier 2 Capital of the Islamic bank, as the case requires.

B is the total Capital holdings of the Islamic Bank.

4.45. Significant investments

(1) This rule applies if:

• (a) an Islamic Bank makes a significant investment in an entity concerned;
• (b) the entity concerned is an unconsolidated entity (that is, the entity is not included in an Islamic Bank’s consolidated returns); and
• (c) an Islamic Bank owns 10% or more of the common shares of the entity concerned.

(2) An Islamic Bank must deduct the total amount of investments in the entity concerned (other than investments in common shares, or other instruments that qualify as CET 1 Capital, of the entity).

(3) For the treatment of investments in common shares, or other instruments that qualify as CET 1 Capital, of an entity concerned, see Rule 4.46 (Deductions from Common Equity Tier 1 Capital).

(4) The amount to be deducted is the net long position (that is, the gross long position net of short positions in the same underlying exposure if the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least 1 year).

(5) Underwriting positions held for more than 5 business days must also be deducted.

(6) If a Capital instrument is required to be deducted and it is not possible to determine whether it should be deducted from CET 1 Capital, Additional Tier 1 Capital or Tier 2 Capital, the deduction must be made from CET 1 Capital.

4.46. Deductions from Common Equity Tier 1 Capital

(1) In addition to the other deductions to CET 1 Capital under this Chapter, deductions may be required to CET 1 Capital under the threshold deduction rule.

(2) The threshold deduction rule provides recognition for particular assets that are considered to have some limited capacity to absorb losses. The following items come within the threshold deduction rule:

• (a) significant investments in the common shares, or other instruments that qualify as CET 1 Capital, of an unconsolidated entity concerned;
• (b) mortgage servicing rights;
• (c) deferred tax assets that relate to temporary differences (for example, allowance for credit losses).

(3) Instead of full deduction, the items that come within the threshold deduction rule receive limited recognition when calculating CET 1 Capital. The total of each of the items in (2) above, do not require adjustment from CET 1 Capital and are risk-weighted at 300% (for items listed on a recognised exchange) or 400% (for items not so listed) provided that:

• (a) each item is no more than 10% of an Islamic Bank’s CET 1 Capital (net of all regulatory adjustments except those under this section); or
• (b) in total, the 3 items are no more than 15% of an Islamic Bank’s CET 1 Capital (net of all regulatory adjustments except those under this Subdivision).
• (c) An Islamic Bank must deduct from CET 1 Capital any amount in excess of the threshold in (3) (a) or (b).