6.1. General

(1) This Chapter sets out the requirements for an Islamic bank’s credit risk management policy (including credit risk assessments and the use of ratings from ECRAs):

• (a) to implement the risk-based framework for Capital adequacy; and
• (b) to ensure the early identification and management of problem assets.

(2) This Chapter also deals with the following means to determine Regulatory Capital and control or mitigate credit risk:

• (a) the Risk-Weighted Assets approach;
• (b) CRM techniques;
• (c) provisioning.

(3) To guard against abuses and to address conflicts of interest, this Chapter requires transactions with related parties to be at arm’s length.

6.2. Credit risk

Credit risk is:

• (a) the risk of default by counterparties; and
• (b) the risk that an asset will lose value because its credit quality has deteriorated.

Guidance

Credit risk may result from on-balance-sheet and off-balance-sheet exposures, including loans and advances, investments, inter-bank lending, securities financing transactions and trading activities. It can exist in a firm’s trading book or banking book.

Examples of sources of credit risks in Islamic Bank

(i) accounts receivable in murabahah contracts

• (ii) counterparty risk in salam contracts
• (iii) accounts receivable and counterparty risk in istisna contracts
• (iv) lease payments receivable in ijarah contracts

(v) sukuk held in the banking book

• (vi) Capital impairment from investments, based on mudarabah or musharakah contracts, held in the banking book.

6.3. Requirements—management of credit risk and problem assets

(1) An Islamic Bank must manage credit risk by adopting a prudent credit risk management policy that allows its credit risk to be identified, measured, evaluated, managed and controlled or mitigated.

(2) The policy must also provide for problem assets to be recognised, measured and reported. The policy must set out the factors that must be taken into account in identifying problem assets.

(3) Problem asset includes impaired credit and other assets if there is reason to believe that the amounts due may not be collectable in full or in accordance with their terms.

6.4. Role of Governing Body—credit risk

An Islamic bank’s governing body must ensure that the Islamic Bank’s credit risk management policy gives an Islamic Bank a comprehensive bank-wide view of its credit risk and covers the full credit lifecycle (including credit underwriting, credit evaluation, and the management of the Islamic bank).

6.5. Credit risk management policy

(1) An Islamic Bank must establish and implement a credit risk management policy:

• (a) that is appropriate for the nature, scale and complexity of its business and for its risk profile; and
• (b) that enables an Islamic Bank to identify, measure, evaluate, manage and control or mitigate credit risk.
• (c) The objective of the policy is to give an Islamic Bank the capacity to absorb any existing and estimated future losses arising from credit risk.

6.6. Policies—general credit risk environment

An Islamic bank’s credit risk management policy must include:

• (a) a well-documented and effectively-implemented process for assuming credit risk that does not rely unduly on external credit ratings;
• (b) well-defined criteria for approving credit (including prudent underwriting standards), and renewing, refinancing and restructuring existing credit;
• (c) a process for identifying the approving AFSA for credit, given its size and complexity;
• (d) effective credit risk administration, including:
• (i) periodic analysis of counterparties’ ability and willingness to repay; and
• (ii) monitoring of documents, legal covenants, contractual requirements, and collateral and other CRM techniques;
• (e) effective systems for the accurate and timely identification, measurement, evaluation, management and control or mitigation of credit risk, and reporting to an Islamic Bank’s governing body and senior management;
• (f) procedures for tracking and reporting exceptions to, and deviations from, credit limits or policies;
• (g) prudent and appropriate credit limits that are consistent with an Islamic Bank’s risk tolerance, risk profile and Capital; and
• (h) effective controls for the quality, reliability and relevance of data and validation procedures.

Guidance

Depending on the nature, scale and complexity of an Islamic bank’s credit risk, and how often it provides credit or incurs credit risk, its credit risk management policy should include:

(1) how an Islamic Bank defines and measures credit risk;

(2) an Islamic Bank’s business aims in incurring credit risk, including:

• (a) identifying the types and sources of credit risk that an Islamic Bank will permit itself to be exposed to (and the limits on that exposure) and those that it will not
• (b) setting out the degree of diversification that an Islamic Bank requires, an Islamic Bank’s tolerance for risk concentrations and the limits on exposures and concentrations
• (c) stating the risk-return trade-off that an Islamic Bank is seeking to achieve;

(3) the kinds of credit to be offered, and ceilings, pricing, profitability, maximum maturities and ratios for each kind of credit;

(4) a ceiling for the total credit portfolio (in terms, for example, of loan-to-deposit ratio, undrawn commitment ratio, maximum amount or percentage of an Islamic Bank’s Capital);

(5) portfolio limits for maximum gross exposures by region or country, by industry or sector, by category of counterparty (such as banks, non-bank financial entities and corporate counterparties), by product, by counterparty and by connected counterparties;

(6) limits, terms and conditions, approval and review procedures and records kept for lending to connected counterparties;

(7) types of collateral, loan-to-value ratios and criteria for accepting guarantees;

(8) the detailed limits for credit risk, and a credit risk structure, that:

• (a) takes into account all significant risk factors, including intra-group exposures
• (b) is commensurate with the scale and complexity of an Islamic Bank’s activities
• (c) is consistent with an Islamic Bank’s business aims, historical performance, and the amount of Capital it is willing to risk;

(9) procedures for:

• (a) approving new products and activities that give rise to credit risk
• (b) regular risk position and performance reporting
• (c) approving and reporting exceptions to limits;

(10) allocating responsibilities for implementing the credit risk management policy and monitoring adherence to, and the effectiveness of, the policy; and

(11) the required information systems, staff and other resources.

6.7. Credit Risk Management Policy

(1) An Islamic bank’s credit risk management policy must require that credit decisions are free of conflicts of interest and are made on an arm’s-length basis. In particular, the credit approval and credit review functions must be independent of the credit initiation function.

(2) An Islamic bank’s credit risk management policy must provide for monitoring the total indebtedness of each counterparty and any risk factors that might result in default (including any significant unhedged foreign exchange risk).

(3) The policy must include stress-testing an Islamic Bank’s credit exposures at intervals appropriate for the nature, scale and complexity of an Islamic Bank’s business and for its risk profile. It must also include a yearly review of stress scenarios, and procedures to make any necessary changes arising from the review.

(4) The policy must state that decisions relating to the following are made at the appropriate level of the Islamic Bank’s senior management or governing body:

• (a) exposures exceeding a stated amount or percentage of an Islamic Bank’s Capital;
• (b) exposures that, in accordance with criteria set out in the policy, are especially risky;
• (c) exposures that are outside an Islamic Bank’s core business.

(5) An Islamic Bank must give the AFSA full access to information in its credit portfolio, including access to staff involved in assuming, managing and reporting on credit risk.

Guidance

(1) This rule excludes arrangements such as an employee loan scheme, so long as the policy ensures that the scheme’s terms, conditions and limits are generally available to employees and adequately addresses the risks and conflicts that arise from loans under it.

(2) The credit risk management policy of an Islamic Bank should clearly set out who has the authority to approve loans to employees.

(3) The authority of a credit committee or credit officer should be appropriate for the products or portfolio and should be commensurate with the committee’s or officer’s credit experience and expertise.

(4) Each authority to approve should be reviewed regularly to ensure that it remains appropriate for current market conditions and the committee’s or officer’s performance.

(5) An Islamic bank’s remuneration policy should be consistent with its credit risk management policy and should not encourage officers to attempt to generate short-term profits by taking an unacceptably high level of risk.

(6) The level at which credit decisions are made should vary depending on the kind and amount of credit and the nature, scale and complexity of an Islamic Bank’s business. For some firms, a credit committee with formal terms of reference might be appropriate; for others, individuals with pre-assigned limits would do.

(7) An Islamic Bank should ensure, through periodic independent audits, which the credit approval function is properly managed and that credit exposures comply with prudential standards and internal limits. The results of audits should be reported directly to the governing body, credit committee or senior management, as appropriate.

6.8. Credit risk assessment

Guidance

i) This section of IBB Rules sets out a standardised approach for credit risk assessment, and requires an Islamic Bank to establish and implement policies to identify, measure, evaluate, manage and control or mitigate credit risk and to calculate its credit risk Capital requirement.

ii) Credit risk assessment under this Part is different from the evaluation (often called credit assessment) made by a firm as part of its credit approval process.

iii) Credit assessment is part of an Islamic Bank’s internal commercial decisionmaking for approving or refusing credit; it consists of the evaluation of a prospective counterparty’s repayment ability. In contrast, credit risk assessment is done by an Islamic Bank (using ratings and risk-weights set out in these rules) as part of calculating its credit risk Capital requirement.

iv) An Islamic Bank involved in loan syndications or consortia should not rely on other parties’ assessments of the credit risk involved but should carry out a full assessment based on its own credit risk management policy.

An Islamic Bank must establish and implement appropriate policies to enable it to assess credit risk when the credit is granted or the risk is incurred, and afterwards. In particular, the policies must enable an Islamic Bank:

• (a) to measure credit risk (including the credit risk of off-balance-sheet items in credit equivalent terms);
• (b) to effectively use its internal credit risk assessment;
• (c) to rate and risk-weight a counterparty;
• (d) to monitor the condition of individual credits;
• (e) to administer its credit portfolio, including keeping the credit files current, getting upto-date financial information on counterparties, and the electronic storage of important documents;
• (f) to ensure that the value of collateral and the value of the other CRM techniques used by an Islamic Bank are assessed regularly
• (g) to assess whether its CRM techniques are effective; and
• (h) to calculate its credit risk Capital requirement.

6.9. Categories of credits

(1) An Islamic Bank must classify credits into 1 of the 5 categories in table 6.1. Nothing in the table prevents an Islamic Bank from classifying a credit under a higher risk category than the table requires.

(2) An Islamic Bank must allocate all credit exposures to the same counterparty to the same risk category.

Table 6.1 Categories of credit

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6.10. Policy on Non-performing assets

An Islamic bank’s credit risk management policy must facilitate the Islamic Bank’s collection of past-due obligations, and its management of problem assets through:

• (a) monitoring of their credit quality;
• (b) early identification and ongoing oversight; and
• (c) review of their classification, provisioning and write-offs.

6.11. Impaired credits

(1) Impaired credit means a credit that is categorised as substandard, doubtful or loss.

(2) A large exposure that is an impaired credit must be managed individually in terms of its valuation, categorisation and provisioning.

(3) The review of impaired credits and other problem assets may be done individually, or by class, but must be done at least once a month.

6.12. Restructuring, refinancing and re-provisioning of credits

(1) A credit is a restructured credit if it has been re-aged, extended, deferred, renewed, rewritten or placed in a workout program. Unless there is good reason to do so, a restructured credit can never be classified as performing.

(2) A restructured credit may be reclassified to a more favourable category, but only by 1 rating up from its category before the restructure. The credit may be reclassified 1 further category up after 180 days of satisfactory performance under the terms of the new contract.

(3) The refinancing of a special mention or impaired credit must not be used to reclassify the credit to a more favourable category.

(4) The AFSA may require a special mention credit to be managed individually, and may set a higher level of provision for the credit, if the AFSA is of the view that market circumstances or any other industry-related concerns require such action.

6.13. Using external credit rating agencies (ECRA)

(1) An Islamic Bank must use only a solicited credit risk rating determined by an ECRA.

(2) A rating is a solicited rating if the rating was initiated and paid for by the issuer of the instrument, the rated counterparty or any other entity in the same corporate group as the issuer or rated counterparty.

(3) An Islamic Bank must use the ratings determined by an ECRA consistently and in accordance with these rules and its credit risk management policy.

(4) A firm that chooses to use ratings determined by an ECRA for exposures belonging to a class must consistently use those ratings for all the exposures belonging to that class. An Islamic Bank must not selectively pick between ECRAs or ratings in determining riskweights.

(5) Unsolicited ratings must not be used except with the written approval of the AFSA or in accordance with a direction of the AFSA. The AFSA may give a written direction setting out conditions that must be satisfied before a firm may use an unsolicited rating.

(6) An Islamic Bank must ensure that the relevant rating takes into account the total amount of the exposure.

Guidance

i) In the standardised approach, external credit ratings from ECRAs are used in determining the risk-weights for exposures to:

• (a) sovereigns
• (b) central banking institutions
• (c) public sector enterprises
• (d) banks and other financial institutions
• (e) corporates.

ii) External credit ratings from ECRAs are not used in relation to:

• (a) regulatory retail portfolios
• (b) residential real estate financing
• (c) non-performing financing
• (d) high risk exposures.

6.14. Multiple assessments

(1) If there is only 1 assessment by an ECRA for a particular claim, that assessment must be used to determine the risk-weight of the claim.

(2) If there are 2 assessments by ECRAs and the assessments map into different riskweights, the higher risk-weight must be applied.

(3) If there are 3 or more assessments with different risk-weights, the assessments corresponding to the 2 lowest risk-weights should be referred to and the higher of those 2 risk-weights must be applied.

6.15. Choosing between issuer and issue ratings

(1) If an Islamic Bank invests in an instrument with an issue-specific rating, the risk-weight to be applied to the instrument must be based on that rating.

(2) If an Islamic Bank invests in an unrated instrument and the issuer of the instrument is assigned a rating that results in a lower risk-weight than the risk-weight normally applied to an unrated position, an Islamic Bank may apply the lower risk-weight to the instrument but only if the claim for the instrument has the same priority as, or is senior to, the claims to which the issuer rating relates. If the instrument is junior to the claims to which the issuer rating relates, an Islamic Bank must apply the risk-weight normally applied to an unrated position.

(3) If an Islamic Bank invests in an unrated instrument and the issuer of the instrument is assigned a rating that results in a higher risk-weight than the risk-weight normally applied to an unrated position, an Islamic Bank must apply the higher risk-weight to the instrument if the claim for that instrument has the same priority as, or is junior to, the claims to which the issuer rating relates.

6.16. Ratings within Financial Group

An Islamic Bank must not use a credit risk rating for 1 entity in a Financial Group to determine the risk-weight for an unrated entity in the same group. If the rated entity has guaranteed the unrated entity’s exposure to An Islamic Bank, the guarantee may be recognised for risk-weighting purposes if it satisfies the criteria for eligible credit risk mitigation.

6.17. Using foreign currency and domestic currency ratings

If an issuer rating is assigned to a counterparty and an Islamic Bank applies a risk-weight to an unrated position based on the rating of an equivalent exposure to the same counterparty:

(a) An Islamic Bank must use that counterparty’s domestic-currency rating for any exposure denominated in the currency of the counterparty’s place of residence or incorporation; and

(b) An Islamic Bank must use that counterparty’s foreign-currency rating for any exposure denominated in a foreign currency.

6.18. Using short-term ratings

(1) A short-term credit risk rating must be used only for short-term claims relating to banks and corporations (such as those arising from the issuance of commercial paper). The rating is taken to be issue-specific and must be used only to assign risk-weights for claims arising from a rated facility.

(2) If a short-term rated exposure is assigned a risk-weight of 50%, an unrated short-term exposure to the same counterparty cannot be assigned a risk-weight lower than 100%.

(3) If a short-term facility of an issuer is assigned a risk-weight of 150% based on the facility’s credit risk rating, all unrated claims of the issuer (whether long-term or short-term) must be assigned a risk-weight of 150%.

6.19. Risk-Weighted Assets (RWA) approach

(1) An Islamic Bank must apply risk-weights to its on-balance-sheet and off-balance-sheet items using the risk-weighted assets approach.

(2) Risk-weights are based on credit ratings or fixed risk-weights and are broadly aligned with the likelihood of counterparty default. An Islamic Bank may use the ratings determined by an ECRA if allowed to do so by these rules.

6.20. Relation to CRM techniques

If a claim or asset to which a risk-weight must be applied by an Islamic Bank is secured by collateral or a guarantee (or there is a Shari’ah-compliant hedging instrument or netting agreement), the CRM techniques specified later in these Rules may be used to reduce an Islamic Bank’s credit risk capital requirement.

6.21. Risk-weight to be applied

(1) An Islamic Bank must apply the risk-weight set out in this section for a claim or asset.

(2) An Islamic Bank must assess all credit exposures (rated or unrated) to determine whether the risk-weights applied to them are appropriate. The determination must be based on each exposure’s inherent risk.

(3) If there are reasonable grounds to believe that the inherent risk of an exposure is significantly higher than that implied by the risk-weight assigned to it, an Islamic Bank must consider the higher risk (and apply a higher risk-weight) in calculating the credit risk Capital requirement.

(4) An Islamic Bank must not rely only on a rating determined by an ECRA to assess the risks associated with an exposure. An Islamic Bank must also carry out its own credit risk assessment of each exposure.

6.22. Commitments included in calculation

An Islamic Bank must take into account all commitments in calculating its credit risk Capital requirement, whether or not those commitments contain material adverse change clauses or other provisions that are intended to relieve an Islamic Bank of its obligations under particular conditions.

6.23. AFSA can determine risk-weights and impose requirements

(1) Despite anything stated in these IBB rules, the AFSA may determine the risk-weighted amount of a particular on-balance-sheet or off-balance-sheet item of an Islamic Bank if the AFSA considers that an Islamic Bank has not risk-weighted the item appropriately. The determination must be in writing.

(2) The AFSA may also impose specific Capital Requirements or limits on significant risk exposures, including those that the AFSA considers to have not been adequately transferred or mitigated.

6.24. Risk-weighted assets approach—on-balance-sheet items

(1) An Islamic Bank’s total risk-weighted on-balance-sheet items is the sum of the riskweighted amounts of each of its on-balance-sheet items.

(2) The risk-weighted amount of an on-balance-sheet item is calculated by multiplying its exposure (after taking into account any applicable CRM technique) by the applicable riskweight set out in table 6.2.

(3) If column 3 of table 6.2 states that the risk-weight is “based on ECRA rating”, the applicable risk-weight for the claim or asset is that set out in table 6.3. If a claim’s or asset’s risk-weight is to be based on the ECRA rating and there is no such rating from an ECRA, an Islamic Bank must apply the risk-weight set out in the last column of table 6.3.

(4) For table 6.2, investment property is land, a building or part of a building (or any combination of land and building) held to earn rentals or for Capital appreciation or both.

(5) Investment property does not include property held for use in the production or supply of goods or services, for administrative purposes, or for sale in the ordinary course of business. A real estate asset owned by an Islamic Bank as a result of a counterparty default is treated as ‘other item’ and risk-weighted at 100% but only for a period of 3 years starting from the date when an Islamic Bank records the asset on its books.

Table 6.2 Risk-weights for on-balance-sheet items

Table 6.3 Risk-weights based on ratings determined by ECRAs

Guidance

In table 6.3, the ratings are given according to Standard & Poor’s conventions. If a claim or asset is not rated by Standard & Poor’s, its ratings must be mapped to the equivalent Standard & Poor’s rating.

6.25. Specialised lending

(1) A specialised lending exposure is risk-weighted at one rating less favourable than the rating that would apply, under table 6.3, to the counterparty to the transaction (or to the party to whom that counterparty has the right of recourse).

(2) Specialised lending is a lending transaction that complies with the following requirements:

• (a) the purpose of the loan is to acquire an asset;
• (b) the cash flow generated by the collateral is the loan’s exclusive (or almost exclusive) source of repayment;
• (c) the loan represents a significant liability in the borrower’s Capital structure;

(d) the credit risk is determined primarily by the variability of the cash flow generated by the collateral (rather than the independent capacity of a broader commercial enterprise).

Guidance

Specialised lending is associated with the financing of projects where the repayment depends on the performance of the underlying collateral. There are 5 sub-classes of specialised lending:

(a) project finance—financing industrial projects based on the projected cash flows of the project;

(b) object finance—financing physical assets based on the projected cash flows obtained primarily through the rental or lease of the assets

(c) commodities finance—financing the reserves, receivables or inventories of exchange-traded commodities where the exposure is paid back based on the sale of the commodity (rather than by the borrower from independent funds);

(d) income-producing real estate finance—financing real estate that is usually rented or leased out by the debtor to generate cash flow to repay the exposure; and

(e) high-volatility commercial real estate finance—financing commercial real estate which demonstrates a much higher volatility of loss rates compared to other forms of specialised lending.

6.26. Risk-weights for unsecured part of claim that is past due for more than 90 days

(1) The risk-weight for the unsecured part of a claim (other than a claim secured by an eligible residential mortgage) that is past due for more than 90 days is:

• (a) 150% if the specific provisions are less than 20% of the past due claim;
• (b) 100% if the specific provisions are 20% or more, but less than 50%, of the past due claim; or
• (c) 50% if the specific provisions are 50% or more of the past due claim.

(2) The risk-weight for the unsecured part of a claim secured by an eligible residential mortgage that is past due for more than 90 days is:

• (a) 100% if the specific provisions are less than 20% of the past due claim; or
• (b) 50% if the specific provisions are 20% or more of the past due claim.

(3) In this rule, eligible residential mortgage means a mortgage on a residential property that is, or will be:

• (a) occupied by the counterparty for residential use; or
• (b) rented out (on a non-commercial basis) for residential use.

6.27. Risk-weighted assets approach—off-balance-sheet items

(1) An Islamic bank’s total risk-weighted off-balance-sheet items is the sum of the risk weighted amounts of its market-related and non market-related off-balance-sheet items.

An off-balance-sheet item must be converted to a credit equivalent amount before it can be risk-weighted.

(2) The risk-weighted amount of an off-balance-sheet item is calculated as follows:

• (a) first, convert the notional principal amount of the item to its on-balance-sheet equivalent (credit equivalent amount).
• (b) second, multiply the resulting credit equivalent amount by the risk-weight in Rule 6.24 (Risk-weighted assets approach—on-balance-sheet items) applicable to the claim or asset.

(3) An Islamic Bank must include all market-related off-balance-sheet items (including on balance-sheet unrealised gains on market-related off-balance-sheet items) in calculating its risk-weighted credit exposures.

(4) A market-related item must be valued at its current market price.

6.28. Conversion of notional amounts—market-related items

(1) An Islamic Bank must calculate the credit equivalent amount of each of its market-related items. Unless the item is covered by an eligible netting agreement, the credit equivalent amount of a market-related off-balance-sheet item is the sum of the current credit exposure and the potential future credit exposure from the item.

(2) Current credit exposure is the absolute mark-to-market value (or replacement cost) of the item.

(3) Potential future credit exposure (also known as ‘the add-on’) is the amount calculated by multiplying the notional principal amount of the item by the relevant credit conversion factor in table 6.4. The notional principal amount of an item is the reference amount used to calculate payment streams between counterparties to the item.

Table 6.4 Credit conversion factors for market-related off-balance-sheet items

(4) A potential future credit exposure must be based on an effective, rather than an apparent, notional principal amount. If the stated notional principal amount of an item is leveraged or enhanced by the structure of the item, an Islamic Bank must use the effective notional principal amount in calculating the potential future credit exposure.

(5) No potential future credit exposure is calculated for a single-currency floating/floating profit rate swap. The credit exposure from such a profit rate swap must be based on markto-market values.

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6.29. Credit conversion factors for items with terms subject to reset

(1) For an item that is structured to settle outstanding exposures after specified payment dates on which the terms are reset (that is, the mark-to-market value of the item becomes zero on the specified dates), the period up to the next reset date must be taken to be the item’s residual maturity. For a profit rate item of that kind that is taken to have a residual maturity of more than 1 year, the credit conversion factor to be applied must not be less than 0.5% even if there are reset dates of a shorter maturity.

(2) For an item with 2 or more exchanges of principal, the credit conversion factor must be multiplied by the number of remaining exchanges under the item.

6.30. Credit conversion factors for single-name swaps

(1) The credit conversion factors for a protection buyer in a single-name total-rate-of-return swap are set out in column 3 of table 6.5. The credit conversion factors for a protection seller are set out in column 4 of that table.

(2) The protection seller in a single-name total-rate-of-return swap is subject to the add-on factor for a closed-out single-name swap only if the protection buyer becomes insolvent while the underlying asset is still solvent. The add-on must not be more than the amount of unpaid premiums.

(3) In this rule, qualifying reference obligation includes obligations arising from items relating to:

• (a) securities that are rated investment grade by at least 2 ECRAs; or
• (b) securities that are unrated (or rated investment grade by only 1 ECRA), but:
• (i) are approved by the AFSA, on application by the Islamic Bank, to be of comparable investment quality; and
• (ii) are issued by an issuer that has its equity included in a main index used in a recognised exchange.

Table 6.5 Credit conversion factors for single-name total-rate-of-return swaps

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6.31. Policies for foreign exchange rollovers

(1) An Islamic Bank must have policies for entering into and monitoring rollovers on foreign exchange transactions. The policies must restrict an Islamic Bank’s capacity to enter into such rollovers, and must be approved by the AFSA.

(2) An Islamic Bank must notify the AFSA if it enters into a rollover outside the approved policy. The AFSA may direct how the rollover is to be treated for Capital adequacy purposes.

(3) An Islamic Bank must not enter into a transaction at an off-market price, unless the transaction is a historical rate rollover on a foreign exchange transaction.

(4) A historical rate rollover on a foreign exchange transaction may be entered into at an offmarket price (instead of current market price).

6.32. Conversion of contracted amounts—non-market-related items

(1) An Islamic Bank must calculate the credit equivalent amount of each of its non-marketrelated items. Unless the item is a default fund guarantee in relation to clearing through a central counterparty, the credit equivalent amount of a non-market-related off-balancesheet item is calculated by multiplying the contracted amount of the item by the relevant credit conversion factor in table 6.6.

(2) If an Islamic Bank arranges a repurchase or reverse repurchase or a securities lending or borrowing transaction between a customer and a third party and provides a guarantee to the customer that the third party will perform its obligations, an Islamic Bank must calculate the credit risk Capital requirement as if it were the principal.

Table 6.6 Credit conversion factors for non-market-related off-balance-sheet items

(3) For item 4 of table 6.6, an exposure from lending securities, or lodging securities as collateral, may be treated as a collateralised transaction.

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6.33. Credit equivalent amount of undrawn commitments

In calculating the credit equivalent amount of a non-market-related off-balance-sheet item that is an undrawn (or partly drawn) commitment, an Islamic Bank must use the undrawn amount of the commitment.

6.34. Irrevocable commitment—off-balance-sheet facilities

For an irrevocable commitment to provide an off-balance-sheet facility, the original maturity must be taken to be the period from the commencement of the commitment until the associated facility expires.

Example

An irrevocable commitment with an original maturity of 6 months with an associated facility that has a nine-month term is taken to have an original maturity of 15 months.

6.35. Risk-weightings for Islamic Financial Contracts

The Rules in the rest of this chapter describe and set out the risk-weights applicable to the main types of Islamic financial contracts employed in carrying out Islamic Banking Business. The risk weight to be applied to the exposure under a contract of a particular type may differ:

(a) at different stages of the contract; or

(b) depending on the enterprise or asset to which the contract relates. Sale-based contracts

6.36. Treatment of murabahah and related contracts

(1) An Islamic Bank is exposed to credit risk under a murabahah contract if the obligor fails to pay the agreed selling price under the contract. Therefore, an Islamic Bank is subject to a Capital charge for credit risk exposure once the asset is sold and payment is due to an Islamic Bank.

(2) For an MPO contract, an Islamic Bank is exposed to credit risk if the obligor (purchase orderer) defaults on its obligation to purchase the asset. Because an Islamic Bank has recourse against the obligor to purchase the asset at the agreed price, the credit risk exposure commences once an Islamic Bank acquires the asset.

(3) In an MPO contract, an Islamic Bank is also exposed to credit risk if the obligor fails to pay the agreed price in accordance with the agreed terms.

Table 6.7A Credit risk-weights for murabahah

Table 6.7B Credit risk-weights for MPO

Table 6.7C Credit risk-weights for MPO

6.37. Treatment of bai bithaman ajil

A bai bithaman ajil (BBA) contract is risk-weighted based on the customer’s type and rating under Rule 6.24.

6.38. Treatment of salam and related contracts

(1) Under a salam contract, an Islamic Bank is exposed to credit risk if the obligor fails to deliver the relevant commodity in accordance with the agreed terms.

(2) An Islamic Bank undertaking parallel salam contracts is exposed to credit risk if the purchaser fails to pay for the relevant commodity. Nevertheless, if the seller under the first salam contract fails to deliver the commodity, an Islamic Bank is not relieved of its obligation to deliver the commodity to the purchaser under the parallel salam contract.

(3) An Islamic Bank must not net a salam exposure against a parallel salam exposure.

Table 6.8A Credit risk-weights for salam without parallel salam

Table 6.8B Credit risk-weights for salam with parallel salam

6.39. Treatment of istisna and related contracts

(1) Under an istisna contract, an Islamic Bank is exposed to credit risk if the obligor fails to pay the price, whether during the manufacturing or construction stage, or on completion of the asset.

(2) Under a parallel istisna contract, an Islamic Bank, as the purchaser of the asset, is exposed to credit risk if the seller fails to deliver the asset at the agreed time and in accordance with the initial istisna buyer’s specification.

(3) The parallel istisna seller’s failure to deliver the asset does not discharge an Islamic Bank’s obligation to deliver the asset to the obligor under the initial istisna contract. Thus, an Islamic Bank is also exposed to the potential loss of making good the shortcoming or acquiring the asset elsewhere.

(4) An Islamic Bank must not net an istisna exposure against a parallel istisna exposure.

Table 6.9A Credit risk-weights for istisna without parallel istisna

Table 6.9B Credit risk-weights for istisna with parallel istisna Lease-based contracts

6.40. Treatment of ijarah and related contracts

(1) An Islamic Bank that is the lessor under an ijarah contract is exposed to credit risk if the lessee fails to pay the rental amount in accordance with the agreement to lease.

(2) In addition, an Islamic Bank is exposed to credit risk if the lessee (lease orderer) defaults on its obligation to lease the asset. In this situation, an Islamic Bank may lease or dispose of the asset to another party, but an Islamic Bank is also exposed to credit risk if the lessee is not able to compensate it for the losses incurred arising from the disposal of the asset.

Table 6.10 Credit risk-weights for ijarah and IMB contracts Equity-based contracts

6.41. Treatment of musharakah (non-diminishing)

(1) Except for diminishing musharakah contracts, all musharakah investments are treated as equity investments

(2) As an equity investment, a musharakah investment must be risk-weighted in accordance with table 6.11A.

Table 6.11A Credit risk-weights for musharakah (non-diminishing)

Table 6.11B Risk-weights for investments in rated funds based on ECRA ratings

Guidance

1. i) In the table, the ratings are given according to Standard & Poor’s conventions. If a claim or asset is not rated by Standard & Poor’s, its ratings must be mapped to the equivalent Standard & Poor’s rating.

(3) The lower risk-weight of 300% applies to an investment that would normally be riskweighted at 400% if, under the musharakah contract, the Islamic Bank is allowed to withdraw its participation within 5 days after giving notice of withdrawal. In any other case, an Islamic Bank may apply a risk-weight of 300% if it can demonstrate:

1. (a) that the lower risk-weight is appropriate for the nature, scale and complexity of an Islamic Bank’s business;
2. (b) that an Islamic Bank can effectively participate in the management of the investment and that such participation would not unduly increase operational risk;
3. (c) an Islamic Bank’s ability to monitor the operations and performance of the investment;
4. (d) that the valuation methods and exit strategies used by an Islamic Bank are appropriate; and
5. (e) that an Islamic Bank has effective reporting and information-sharing systems.

6.42. Treatment of diminishing musharakah

The risk-weight for a diminishing musharakah contract depends on the category of the enterprise or asset to which the contract relates.

Table 6.12 Credit risk-weights for diminishing musharakah

6.43. Treatment of mudarabah and related contracts

This rule applies to risk-weighting for an exposure arising from a mudarabah contract, except if the AFSA examines the exposure and determines it to be an equity investment. If the AFSA determines that the exposure is an equity investment, the risk-weights set out in rule 6.41 for musharakah apply.

Table 6.13A Credit risk-weights for mudarabah investments (other than project finance)

Table 6.13B Credit risk-weights for mudarabah investments in project finanance

6.44. Treatment of qardh

Under a qardh contract, an Islamic Bank is exposed to credit risk if the borrower fails to repay the principal loan amount in accordance with the contract. Hence, the credit risk exposure arises at the time the contract becomes binding.

Table 6.14 Credit risk-weights for qardh Service-based contracts

6.45. Treatment of wakalah

An Islamic Bank is exposed to credit risk if an Islamic Bank enters into a financing contract based on wakalah.

Table 6.15A Credit risk-weights for wakalah investments (other than project finance)

Table 6.15B Credit risk-weights for wakalah investments in project finance

6.46. Credit risk mitigation

(1) An Islamic Bank is able to obtain Capital relief by using Shari’ah-compliant CRM techniques. The techniques must be viewed as complementary to, rather than a replacement for, thorough credit risk assessment.

(2) Eligible CRM techniques include:

• (a) accepting collateral, standby letters of credit and guarantees;
• (b) using Shari’ah-compliant hedging instruments; and
• (c) using netting agreements.

Guidance

i) Credit risk mitigation using collateral and guarantees is usually dealt with at the time credit is granted. In contrast, hedging instruments and netting agreements are often used after the credit is granted, or used to manage an Islamic Bank’s overall portfolio risk.

ii) An Islamic Bank should not rely excessively on collateral or guarantees to mitigate credit risk. While collateral or guarantees may provide secondary protection to an Islamic Bank if the counterparty defaults, the primary consideration for credit approval should be the counterparty’s repayment ability.

iii) An Islamic Bank that provides mortgages at high loan-to-value ratios should consider the need for alternative forms of protection against the risks of such lending, in order to protect itself against the risk of a fall in the value of the property.

(3) In choosing a CRM technique, an Islamic Bank must consider:

• (a) an Islamic Bank’s knowledge of, and experience in using, the technique;
• (b) the cost-effectiveness of the technique;
• (c) the type and financial strength of the counterparties or issuers;
• (d) the correlation of the technique with the underlying credits;
• (e) the availability, liquidity and realisability of the technique;
• (f) the extent to which documents in common use (for example, the ISDA Master Agreement) can be adopted; and
• (g) the degree of recognition of the technique by financial services regulators.

6.47. Requirements—CRM techniques

1) An Islamic bank’s credit risk management policy must set out the conditions under which CRM techniques may be used. The policy must enable an Islamic Bank to manage CRM techniques and the risks associated with their use.

(2) An Islamic Bank must analyse the protection given by CRM techniques to ensure that any residual credit risk is identified, measured, evaluated, managed and controlled or mitigated.

(3) The policy must include procedures for:

(a) setting mark-up rates according to the risk rating of the counterparties;

(b) taking account of governing laws for contracts relating to financing transactions; and

(c) assessing the risks and obligations from an Islamic Bank’s own exposures in parallel transactions such as those in salam and istisna.

(4) If an Islamic Bank accepts collateral, its policy must state the types of collateral that it will accept, and the basis and procedures for valuing collateral.

(5) If an Islamic Bank uses netting agreements, it must have a netting policy that sets out its approach. The netting policy must provide for monitoring netting agreements and must enable an Islamic Bank to monitor and report netted transactions on both gross and net bases.

6.48. Obtaining Capital relief

(1) To obtain Capital relief, the CRM technique and every document giving effect to it must be binding on all parties and enforceable in all the relevant jurisdictions.

Example

When accepting collateral, an Islamic Bank must ensure that any necessary legal procedures have been followed, to ensure that the collateral can be enforced.

(2) An Islamic Bank must review the enforceability of a CRM technique that it uses. An Islamic Bank must have a well-founded legal basis for any conclusion about enforceability, and must carry out further reviews to ensure that the technique remains enforceable.

(3) The effects of a CRM technique must not be double-counted. An Islamic Bank is not allowed to obtain Capital relief if:

• (a) the risk-weight for the claim or asset is based on an issue-specific rating; and
• (b) the ECRA that determined the rating had taken the technique into consideration in doing so.

Guidance

An Islamic Bank should consider whether independent legal opinion should be sought on the enforceability of documents. The documents should be ready before an Islamic Bank enters into a contractual obligation or releases funds.

6.49. Standard haircuts to be applied

(1) An Islamic Bank must use the standard haircuts (expressed in percentages) set out in tables 6.16A and 6.16B in any calculation relating to credit risk mitigation. The haircuts are applied after risk mitigation to calculate adjusted exposures and are intended to take into account possible future price fluctuations.

(2) In table 6.16A: other issuers include banks, corporates, and public sector enterprises that are not treated as sovereigns. sovereign includes a multilateral development bank, and a non-commercial public sector enterprise, that has a zero per cent risk-weight.

Table 6.16A Haircuts for sukuk

Table 6.16B Haircuts for other instruments

(3) For item 7 of table 6.16B, if a guarantee is denominated in a currency different from that in which the exposure is denominated (that is, there is a currency mismatch), the amount of the exposure that is covered must be reduced using the following formula:

where:

G is the nominal amount of the guarantee.

Hfx is 8% or the haircut under whichever of subrule (1) or (4) applies.

Depending on the frequency of the revaluation of the guarantee, the 8% haircut (which is based on a 10-business-day holding period) must be scaled up using the following formula:

where:

H is the scaled-up haircut.

H10 is the standard haircut under table 6.16A or 6.16B.

N is the number of business days between revaluations for secured transactions.

(4) If the mismatched currencies are both pegged to the same reference currency, or if 1 of them is pegged to the other, Hfx is zero (and no haircut applies).

6.50. Capital relief from collateral

(1) An Islamic Bank may obtain Capital relief by accepting Shari’ah-compliant eligible collateral.

(2) Collateral may be lodged by the counterparty of an Islamic Bank holding a credit exposure (or by a third party on behalf of the counterparty).

(3) An Islamic Bank must enter into a written agreement with the party lodging the collateral. The agreement must establish an Islamic Bank’s direct, explicit, irrevocable and unconditional recourse to the collateral.

Guidance

In the case of cash collateral, the recourse may be in the form of a contractual right of set-off on credit balances. A common-law right of set-off is, on its own, insufficient to satisfy this rule.

(4) If collateral is lodged by a third party, the third party must guarantee the counterparty’s obligation to an Islamic Bank and must indemnify an Islamic Bank if the counterparty fails to fulfil its obligation. An Islamic Bank must ensure that the guarantee does not fail for lack of consideration.

(5) The mechanism by which collateral is lodged must allow an Islamic Bank to liquidate or take possession of the collateral in a timely way. An Islamic Bank must take all steps necessary to satisfy the legal requirements applicable to its interest in the collateral.

(6) There must not be a significant positive correlation between the value of the collateral and the credit quality of the borrower.

Guidance

(1) An Islamic Bank should have clear and robust procedures for the liquidation of collateral to ensure that the legal conditions for declaring default and liquidating the collateral are observed.

(2) An Islamic Bank should consider whether, in the event of default, notice to the party that lodged the collateral would be needed before an Islamic Bank could have recourse to it.

6.51. Valuing collateral

Collateral accepted by an Islamic Bank must be valued at its net realisable value, taking into account prevailing market conditions. That value must be monitored at appropriate intervals, and the collateral must be regularly revalued.

Guidance

(1) The net realisable value of some collateral may be readily available (for example, collateral that is marked-to-market regularly). Other collateral may be more difficult to value and may require knowledge and consideration of prevailing market conditions.

2) The method and frequency of monitoring and revaluation depend on the nature of the collateral. For example, commercial property might be revalued every year, whereas securities accepted as collateral are usually marked-to-market daily. Residential property may not need to be revalued every year, but information should be sought about general market conditions.

6.52. Eligible collateral for Islamic banks

(1) The following are eligible collateral if they satisfy the criteria in (2) below:

(a) gold bullion;

(b) cash;

(c) hamish jiddiyah or refundable security deposit taken by an Islamic Bank against damages if:

(i) a purchase orderer in an MPO contract defaults on its obligation to purchase the asset; or

• (ii) a lease orderer in an ijarah contract defaults on its obligation to lease the asset;

(d) urbun or earnest money held by a firm as collateral to guarantee contract performance;

(e) sukuk that are assigned, by an ECRA, a rating of:

(i) for sovereign or non-commercial public sector enterprise securities that are eligible for zero per cent risk-weight—at least BB-;

• (ii) for short-term debt securities—at least A-3/P-3; or
• (iii) for any other securities—at least BBB-;

(f) subject to sub-rule (3), sukuk that have not been assigned a rating by an ECRA, if:

(i) the securities are issued by an Islamic Bank (or by a conventional bank that is outside the AIFC and that has an Islamic window or subsidiary operation) as senior debt and are listed on a recognised exchange;

• (ii) all rated issues of the same seniority issued by that firm or bank have a credit rating of at least BBB- (for long-term debt instruments) or A-3/P-3 (for shortterm debt instruments); and
• (iii) an Islamic Bank or bank and the holder of the collateral have no information suggesting that the securities should have a rating below BBB- or A 3/P-3;

(g) Shari’ah-compliant equities (including convertible bonds) that are included in a main index;

(h) units in Islamic collective investment schemes;

(i) tracker funds, mutual funds and undertakings for collective investments in transferable securities (UCITS) if:

• (i) a price for the units is publicly quoted daily; and
• (ii) the funds or UCITS are limited to investing in instruments listed in (i);

(j) Shari’ah-compliant equities (including convertible bonds) that are not included in a main index but are listed on a recognised exchange, and funds and UCITS described in paragraph (i) that include such equities.

(2) For collateral to be eligible collateral, it must be lodged for at least the life of the exposure, and must be marked-to-market at least once every 6 months. The release of collateral must be conditional on the repayment of the exposure, but collateral may be reduced in proportion to the amount of any reduction in the exposure.

(3) Collateral in the form of securities issued by the counterparty or a person connected to the counterparty is not eligible collateral.

(4) Takaful contracts, put options, and forward sales contracts or agreements are not eligible collateral.

6.53. When physical assets may be eligible collateral

(1) An Islamic Bank may accept as eligible collateral, by way of pledge, a specified asset that can be lawfully owned, and is saleable and deliverable. The pledge must be enforceable and the asset must be free of encumbrance.

(2) An asset leased under an ijarah or IMB contract may be repossessed by an Islamic Bank as lessor in case of default by the lessee. As such, it fulfils the function of collateral for purposes of credit risk mitigation.

6.54. Forms of cash collateral

Cash collateral, in relation to a credit exposure, means collateral in the form of:

• (a) PSIAs, notes or coins on deposit with an Islamic Bank holding the exposure, if supported by an agreement that gives an Islamic Bank the right of set-off against the amount of receivables due from the customer;
• (b) certificates of deposit, bank bills and similar instruments issued by the Islamic Bank holding the exposure; or
• (c) cash-funded credit-linked notes issued by an Islamic Bank against exposures in its banking book, if the notes satisfy the criterion for Shari’ah-compliant hedging instruments.

6.55. Holding eligible collateral

(1) Eligible collateral must be held by:

• (a) an Islamic Bank;
• (b) a branch of an Islamic Bank;
• (c) an entity that is a member of the financial group of which an Islamic Bank is a member;
• (d) an independent custodian; or
• (e) a central counterparty.

(2) The holder of cash collateral in the form of a certificate of deposit or bank bill issued by an Islamic Bank must keep possession of the instrument while the collateralised exposure exists.

(3) If the collateral is held by an independent custodian or central counterparty, an Islamic Bank must take reasonable steps to ensure that the holder segregates the collateral from the holder’s own assets.

(4) If collateral is held by a branch of an Islamic Bank which is not regulated by the AFSA, the agreement between an Islamic Bank and the party lodging the collateral must require the branch to act in accordance with the agreement.

6.56. Risk-weight for cash collateral

(1) An Islamic Bank may apply a zero per cent risk-weight to cash collateral if the collateral is held by an Islamic Bank itself.

(2) An Islamic Bank may apply a zero per cent risk-weight to cash collateral held by another member of the financial group of which an Islamic Bank is a member if the agreement between an Islamic Bank and the party lodging the collateral requires the holder of the collateral to act in accordance with the agreement.

(3) If cash collateral is held by another Islamic Bank under a non-custodial arrangement, and the collateral is lodged with an Islamic Bank under an agreement that establishes an Islamic Bank’s irrevocable and unconditional recourse to the collateral, the exposure covered by the collateral (after any necessary haircuts for currency risk) may be assigned the risk-weight of an Islamic Bank holding the collateral.

(4) If cash collateral is held by an independent custodian (other than a central counterparty), the risk-weight of the holder of the collateral must be used. However, an Islamic Bank may apply a zero per cent risk-weight to notes and coins held by an independent custodian.

6.57. Risk-weight for claims

(1) The secured part of a claim must be risk-weighted at whichever is the higher of 20% and the risk-weight applicable to the eligible collateral. However, a risk-weight lower than 20% may be applied to the secured part if rule 6.58 applies.

(2) The unsecured part of the claim must be weighted at the risk-weight applicable to the original counterparty.

6.58. Risk-weights less than 20%

(1) A zero per cent risk-weight may be applied to a collateralised transaction if:

• (a) there is no currency mismatch; and
• (b) any one of the following applies:
• (i) the collateral is in the form of sovereign securities;
• (ii) the collateral is in the form of cash collateral on deposit with the Islamic Bank; or
• (iii) if the collateral is in the form of non-commercial public sector enterprise securities, then the securities must be eligible for zero per cent risk-weight and the market value of the collateral must be discounted by 20%.

(2) A zero per cent risk-weight may be applied to an OTC Shari’ah-compliant hedging transaction if there is no currency mismatch and the transaction is fully collateralised by cash and marked-to-market daily.

(3) A 10% risk-weight may be applied to an OTC Shari’ah-compliant hedging transaction to the extent that the transaction is collateralised by sovereign or non-commercial public sector enterprise securities that are eligible for zero per cent risk-weight.

6.59. Capital relief from guarantees

(1) Capital relief is allowed from a guarantee if the guarantor is an eligible guarantor and the guarantee satisfies the criteria in (2) to (4) below. Before accepting a guarantee, an Islamic Bank must consider the guarantor’s legal and financial ability to fulfil the guarantee.

(2) A guarantee must be a direct claim on the guarantor and must clearly state the extent of the cover. A letter of comfort is not a guarantee for the purposes of this Division.

(3) A guarantee must be irrevocable. It must not include a term or condition:

(a) that allows the guarantor to cancel it unilaterally; or

(b) that increases the effective cost of cover if the credit quality of the guaranteed exposure deteriorates.

(4) A guarantee must be unconditional. It must not include a term or condition (outside the direct control of an Islamic Bank) that allows the guarantor not to indemnify an Islamic Bank in a timely way if the counterparty defaults.

(5) If a claim on a counterparty is secured by a guarantee, the part of the claim that is covered by the guarantee may be weighted at the risk-weight applicable to the guarantor. The unsecured part of the claim must be weighted at the risk-weight applicable to the original counterparty.

Guidance

i) The irrevocability condition does not require that the guarantee and the exposure be maturity matched. However, it does require that the agreed maturity should not be reduced by the guarantor after the Islamic Bank accepts the guarantee.

ii) This rule applies to a guarantee that provides part coverage under which an Islamic Bank and the guarantor share losses on a pro-rata basis.

6.60. Eligible guarantors

(1) Eligible guarantor means:

• (a) Republic of Kazakhstan, any other sovereign or any entity treated as a sovereign;

or

• (b) any other entity (including a public sector enterprise not treated as a sovereign) that has:
• (i) a risk-weight of 20% or lower; and
• (ii) a lower risk-weight than the counterparty.

(2) A parent entity, subsidiary or affiliate of a counterparty may be an eligible guarantor if it has a lower risk-weight than the counterparty.

6.61. Capital relief from hedging instruments

(1) Capital relief is allowed if an Islamic Bank uses a Shari’ah-compliant hedging instrument.

Each of the following is a Shari’ah-compliant hedging instrument if it satisfies (2) below:

• (a) a total-rate-of-return swap for which an Islamic Bank has recorded any deterioration in the value of the underlying exposure, in addition to recording the net payments received on the swap as net income;
• (b) a cash-funded credit-linked note;
• (c) a first and second-to-default hedging instrument basket product.

(2) The hedging instrument must not include a term or condition that terminates the credit protection, or increases an Islamic Bank’s costs for the protection, if the credit quality of the underlying exposure deteriorates.

(3) If a claim on a counterparty is protected by a Shari’ah-compliant hedging instrument, the part of the claim that is protected may be weighted at the risk-weight applicable to the issuer of the instrument. The unprotected part of the claim must be weighted at the riskweight applicable to the original counterparty.

6.62. Capital relief from netting agreements

(1) An Islamic Bank is able to obtain Capital relief from a netting agreement with a counterparty only if the agreement is an eligible netting agreement.

(2) An Islamic Bank that has entered into a netting agreement must consistently net all the transactions included in the agreement. An Islamic Bank must not selectively pick which transactions to net.

(3) The following kinds of transactions may be netted:

(a) financing assets and deposits, but only if:

(i) an Islamic Bank is able to determine, at all times, the assets and deposits that are subject to netting under the agreement; and

• (ii) the deposits satisfy the criteria for eligible collateral;

(b) securities financing transactions;

(c) OTC Shari’ah-compliant hedging transactions.

(4) The transactions listed in Rule (3) above may be netted across both the banking and trading books of an Islamic Bank, if the netted transactions satisfy the criteria in rule 6.63 and across different market-related products to the extent that they are recognised as market-related transactions.

Guidance

i) Securities financing transactions are not included as part of market-related transactions.

ii) A netting agreement may include the netting of OTC Shari’ah-compliant hedging transactions:

6.63. Criteria for eligible netting agreements

(1) To be an eligible netting agreement, a netting agreement:

• (a) must be in writing;
• (b) must create a single obligation covering all transactions and collateral included in the agreement and giving the Islamic Bank the following rights:
• (i) the right to terminate and close-out, in a timely way, all the transactions included in the netting agreement;
• (ii) the right to net the gains and losses on those transactions (including the value of any collateral) so that an Islamic Bank either has a claim to receive, or an obligation to pay, only the net sum of the close-out values of the individual transactions;
• (iii) the right to liquidate or set-off collateral if either party to the agreement fails to meet its obligations because of default, liquidation, bankruptcy or other similar circumstances;

(c) must not be subject to a walkaway clause; and

(d) must be supported by a written and reasoned legal opinion that complies with rules 6.64 to 6.65.

(2) An Islamic Bank must not recognise a netting agreement as an eligible netting agreement if it becomes aware that a financial services regulator of the counterparty is not satisfied that the agreement is enforceable under the laws of the regulator’s jurisdiction. This rule applies regardless of any legal opinion obtained by an Islamic Bank.

(3) A netting agreement is not an eligible netting agreement if there is doubt about its enforceability.

6.64. Legal opinion must cover transaction

(1) An Islamic Bank must ensure that a netted transaction is covered by an appropriate legal opinion.

(2) In calculating the net sum due to or from a counterparty, an Islamic Bank must exclude netted transactions for which it has not obtained a satisfactory legal opinion applicable in the relevant jurisdiction. An excluded transaction must be reported on a gross basis.

6.65. Conclusion about enforceability

(1) For rule 6.63 (1) (d), the legal opinion must conclude that, in the event of default, liquidation, bankruptcy or other similar circumstances of a party to the netting agreement, the Islamic bank’s claims and obligations are limited to the net sum calculated under the netting agreement in accordance with the applicable law.

(2) In particular, the legal opinion must conclude that, in the event of insolvency or external administration of a counterparty, a liquidator or administrator of the counterparty will not be able to claim a gross amount from an Islamic Bank while only being liable to pay a dividend in insolvency to an Islamic Bank (as separate money flows).

(3) The AFSA expects the legal opinion to deal with the issue of which of the following laws applies to the netting:

• (a) the law of the jurisdiction in which the counterparty is incorporated or formed (or, in the case of an individual, resides)
• (b) if an overseas branch of the counterparty is involved—the law of the jurisdiction in which the branch is located
• (c) the law that governs the individual transactions
• (d) the law that governs any contract or agreement necessary to give effect to the netting.

Guidance

In some countries, there are provisions for the authorities to appoint an administrator to a troubled bank. Under statutory provisions applying in those countries, the appointment of an administrator might not constitute a ground for triggering a netting agreement. Such provisions do not prevent the recognition of an affected netting agreement if the agreement can still take effect if the bank under administration does not meet its obligations as they fall due.

6.66. Requirements—legal opinion

(1) Before an Islamic Bank uses a legal opinion to support a netting agreement, an Islamic Bank:

• (a) must ensure that the opinion is not subject to assumptions or qualifications that are unduly restrictive;
• (b) must review the assumptions about the enforceability of the agreement and must ensure that they are specific, factual and adequately explained in the opinion; and
• (c) must review and assess the assumptions, qualifications and omissions in the opinion to determine whether they give rise to any doubt about the enforceability of the agreement.

(2) An Islamic Bank must have procedures to monitor legal developments and to ensure that its netting agreements continue to be enforceable. An Islamic Bank must update the legal opinions about the agreements, as necessary, to ensure that the agreements continue to be eligible.

(3) An Islamic Bank may rely on a legal opinion obtained on a group basis by another member of the financial group of which it is a member if an Islamic Bank and the other member have satisfied themselves that the opinion covers a netting agreement to which an Islamic Bank is a counterparty.

(4) An Islamic Bank must report a transaction on a gross basis if there is any doubt about, or any subsequent legal development affects, the enforceability of the agreement.

6.67. Relying on general legal opinions

(1) An Islamic Bank may rely on a general legal opinion about the enforceability of netting agreements in a particular jurisdiction if an Islamic Bank is satisfied that the type of netting agreement is covered by the opinion.

(2) An Islamic Bank must satisfy itself that the netting agreement with a counterparty and the general legal opinion are applicable to each transaction and product type undertaken with the counterparty, and in all jurisdictions where those transactions are originated.

6.68. Netting of positions across books

An Islamic Bank may net positions across its banking and trading books only if:

• (a) the netted transactions are marked-to-market daily; and
• (b) any collateral used in the transactions satisfies the criteria for eligible collateral in the banking book.

6.69. Monitoring and reporting of netting agreements

(1) If directed by the AFSA, an Islamic Bank must demonstrate that its netting policy is consistently implemented, and that its netting agreements continue to be enforceable.

(2) An Islamic Bank must keep adequate records to support its use of netting agreements and to be able to report netted transactions on both gross and net bases.

(3) An Islamic Bank must monitor its netting agreements and must report and manage:

• (a) roll-off risks;
• (b) exposures on a net basis; and
• (c) termination risks;

for all the transactions included in a netting agreement.

6.70. Collateral and guarantees in netting

(1) An Islamic Bank may take collateral and guarantees into account in calculating the riskweight to be applied to the net sum under a netting agreement.

(2) An Islamic Bank may assign a risk-weight based on collateral or a guarantee only if:

• (a) the collateral or guarantee has been accepted or is otherwise subject to an enforceable agreement; and
• (b) the collateral or guarantee is available for all the individual transactions that make up the net sum of exposures calculated.

(3) An Islamic Bank must ensure that provisions for applying collateral or guarantees to netted exposures under a netting agreement comply with the requirements for eligible collateral and guarantees in these rules.

6.71. Provisioning

(1) Provisioning means setting aside an amount to cover expected losses on special mention credits, impaired credits and other problem assets, based on loan-loss probability. Provisioning is made before profit is earned.

(2) Depending on the nature, scale and complexity of an Islamic Bank’s business, and of the credit it provides, an Islamic Bank’s provisioning policy must set out:

(a) the areas of its business to which the policy applies;

(b) whether an Islamic Bank uses different approaches to those areas, and the significant differences in approach;

(c) who is responsible for regularly monitoring its assets, to identify problem or potential problem assets, and the factors it takes into account in identifying them;

(d) the extent to which the value of any collateral or guarantees that an Islamic Bank holds affects the need for, or the level of, provisions;

(e) the basis on which an Islamic Bank makes its provisions, including the extent to which their levels are left to managerial judgement or to a committee;

(f) the methods, debt management systems or formulae used to set the levels of provisions and the factors that must be considered in deciding whether the provisions are adequate;

(g) the reports to enable an Islamic Bank’s governing body and senior management to ensure that an Islamic Bank maintains adequate provisions;

(h) the procedures and responsibilities for arrears management and the recovery of exposures in arrears or exposures that have had provisions made against them;

(i) the procedures for writing off and writing back provisions; and

(j) the procedures for calculating and making provisions for contingent and other liabilities (such as contingent liabilities that have crystallised from acceptances, endorsements, guarantees, performance bonds, indemnities, irrevocable letters of credit and the confirmation of documentary credits).

6.72. Making provisions

(1) An Islamic Bank must ensure that an Islamic Bank maintains provisions that, taken together, are prudent, reasonable and adequate to absorb credit losses, given the facts and circumstances. The losses covered must include losses incurred, losses incurred but not yet reported, and losses estimated but not certain to arise, extending over the life of the individual credits that make up its credit portfolio.

(2) An Islamic Bank must also ensure that provisions and write-offs are timely and reflect realistic repayment and recovery expectations, taking into account market and macroeconomic conditions. An Islamic Bank must consider all the significant factors that affect the likelihood of collecting on the transactions that make up its credit portfolio and the estimated future credit losses on those transactions.

(3) An Islamic Bank must make provisions that in total meet the requirements in table 6.17.

Table 6.17 Provisioning requirements

(4) Provisions may be general (assessed collectively against the whole of a portfolio) or specific (assessed against individual credits), or both.

(5) An Islamic Bank must take into account off-balance-sheet exposures in its categorisation of credits and in provisioning.

Guidance

No provisioning is necessary for any off-balance-sheet exposures that can be unilaterally cancelled by an Islamic Bank.

6.73. Review of levels

The levels of provisions and write-offs must be reviewed regularly to ensure that they are consistent with identified and estimated losses.

Guidance

i) A review of a firm’s write-offs can help identify whether an Islamic Bank’s provisioning policy results in over-provisioning or under-provisioning.

ii) The AFSA regularly assesses trends and concentrations in risk and risk build-up across financial entities in relation to problem assets. In making the assessment, the AFSA takes into account any observed concentration in the CRM techniques used by firms and the potential effect on the efficacy of those techniques in reducing loss. The authority would consider the adequacy of provisions for a firm (and the industry in general) in the light of the assessment.

iii) The AFSA might seek the opinion of external experts in assessing the adequacy of a firm’s policies for grading and classifying its assets and the appropriateness and robustness of the levels of its provisions.

6.74. Prohibition on evergreening

An Islamic Bank must not restructure, refinance or reclassify assets with a view to evergreen its credit exposures, leading to such exposures being classified in a higher category thereby circumventing the requirements on provisioning. In particular, impaired credits must not be refinanced with the aim of classifying them as standard or special mention credits.

6.75. AFSA can reclassify assets

(1) The AFSA may at any time require an Islamic Bank to demonstrate that an Islamic Bank’s classification of its assets, and its provisions, are adequate for prudential purposes.

(2) The AFSA may require an Islamic Bank to reclassify its assets or increase the levels of its provisions if the AFSA considers that the asset classifications are inaccurate, or the provisions are inadequate, for prudential purposes.

Guidance: Example

If the AFSA considers that existing or anticipated deterioration in asset quality is of concern or if the provisions do not fully reflect expected losses, the AFSA may require an Islamic Bank to adjust its classifications of individual assets, increase its levels of provisions or Capital and, if necessary, impose other remedial measures.

6.76. Reporting to governing body

(1) An Islamic bank’s governing body must obtain timely information on the condition of an Islamic Bank’s assets, including the classification of assets, the levels of provisions and problem assets.

(2) The information must include summary results of the latest asset review, comparative trends in the overall quality of problem assets, and measurements of existing or anticipated deterioration in asset quality and losses expected.

6.77. Transactions with related parties

(1) To guard against abuses in lending to related parties and to address conflicts of interest, this Part requires transactions with related parties to be at arm’s length and subject to appropriate supervision and limits.

(2) Related-party transactions must be interpreted broadly. Related party transactions include on-balance-sheet and off-balance-sheet credit exposures, service contracts, asset purchases and sales, construction contracts, lease agreements, borrowing and write-offs.

6.78. Concept of related parties

(1) The concept of parties being related to an Islamic Bank is used in these rules in relation to parties over which an Islamic Bank exercises control or parties that exercise control over an Islamic Bank. The concept is primarily used in relation to the requirement that an Islamic Bank’s transactions be at arm’s length.

(2) In contrast, the concept of parties being connected to one another (which is discussed with concentration risk in Chapter 9) is used in these rules to measure concentration risk and large exposures.

(3) It is of course possible for connected counterparties to be related to the Islamic Bank holding the exposure concerned.

(4) Related parties, of an Islamic Bank, includes:

• (a) any other member of an Islamic Bank’s corporate group;
• (b) any individual who is able to exercise significant influence over an Islamic Bank;
• (c) any affiliate of an Islamic Bank; and
• (d) any entity that the AFSA directs an Islamic Bank to include.

Guidance

Related party is wider than a firm’s corporate group in that it includes individuals. Related parties include the Islamic Bank’s subsidiaries and major stock holders; members of its governing body; its senior management and key employees.

6.79. Role of governing body—related parties

(1) An Islamic bank’s governing body must ensure that an Islamic Bank’s policies relating to related-party transactions are complied with and that any exceptions are reported to the appropriate level of the senior management, and, if necessary, to the governing body.

(2) The governing body must also ensure that an Islamic Bank’s senior management monitors transactions with related parties, takes appropriate steps to control or mitigate the risks from such transactions and writes off exposures to related parties only in accordance with an Islamic Bank’s policies.

(3) The governing body must approve transactions with related parties, and the write-off of related-party exposures, if such transactions or write-off exceeds specified amounts or otherwise poses any special risk.

6.80. Policies—transactions with related parties

(1) An Islamic bank’s policy must establish:

• (a) effective systems to identify, monitor and report individual and total exposures to, and transactions with, related parties;
• (b) procedures to prevent a member of the governing body, a member of an Islamic Bank’s senior management or any other person who stands to gain a benefit from a related-party transaction from being part of the process of granting and managing the transaction;
• (c) well-defined criteria for writing-off exposures to related parties;
• (d) prudent and appropriate limits to prevent or address conflicts of interest; and
• (e) procedures for tracking and reporting exceptions to, and deviations from, limits or policies.

6.81. Transactions must be arm’s length

A transaction with a related party must not be undertaken on terms more favourable to the party than a corresponding transaction with a non-related party.

Guidance

Favourable terms could relate to credit assessment, tenor, fees, amortisation schedule and need for collateral. An exception for beneficial terms could be appropriate if it is part of an employee’s remuneration package.

6.82. Limits on lending to related parties

An Islamic Bank must not enter into a transaction that would cause it to exceed the limits set out in table 6.18, without AFSA’s written approval to do so.

Table 6.18 Limits on Islamic Banks’ exposure to related parties

6.83. Powers of the AFSA

(1) Despite anything in these rules, the AFSA may, in writing, set specific limits on an Islamic bank’s exposures to a related party or to related parties in total.

(2) The AFSA may direct such exposures to be deducted from Regulatory Capital when assessing capital adequacy or direct that such exposures be collateralised.