7.1. General

This Chapter sets out the requirements for an Islamic Bank’s policies to identify, measure, evaluate, manage and control or mitigate concentrations of risk. This Chapter also sets limits on an Islamic Bank’s exposures to individual counterparties and connected counterparties.

7.2. Concept of connected parties

(1) The concept of parties being connected to one another is used in these rules in relation to counterparties or issuers to which an Islamic Bank has exposures. Connected counterparties are the basis for the measurement of concentration risk and large exposures.

(2) In contrast, the concept of parties being related to the Islamic Bank (which is discussed with credit risk in Chapter 6) is primarily used in relation to the requirement that an Islamic Bank’s transactions be at arm’s length.

(3) It is of course possible for a firm’s related parties to be connected counterparties (such as when an Islamic Bank has exposures to them).

7.3. Connected parties

(1) A party is connected to another party if they are linked by:

• (a) cross guarantees;
• (b) common ownership;
• (c) common management;
• (d) one having the ability to exercise control over the other, whether direct or indirect;
• (e) financial interdependency—that is, the financial soundness of one may affect the financial soundness of the other; or
• (f) any combination of the factors mentioned in paragraphs (a) to (e).

Guidance

i) Parties would be connected if the same persons significantly influence the governing body of each of them.

ii) Parties would be connected if one of them has an exposure to the other that was not incurred for the clear commercial advantage of both of them and is not on arm’s length terms.

iii) Parties would be connected if they are so closely linked that:

• a) the insolvency or default of one is likely to be associated with the insolvency or default of the other;
• b) it would be prudent when assessing the financial condition or creditworthiness of one to consider that of the other; or
• c) there is, or is likely to be, a close relationship between their financial performance.

iv) Parties would be connected if an Islamic Bank has exposures to them and any loss to an Islamic Bank on any of the exposures to one of the parties is likely to be associated with a loss to an Islamic Bank with respect to at least 1 exposure to each of the others.

v) A counterparty may be connected to another counterparty by other linkages that, in the Islamic Bank’s assessment, connect the counterparties as constituting a single risk.

vi) A connected party can be an individual or other entity.

vii) Two or more individuals or legal persons would constitute a single risk if they are so connected that, if one of them were to experience financial problems, the other or others would be likely to encounter repayment difficulties.

viii) Connected counterparties should be identified and the procedures to manage the combined credit risk considered. An Islamic Bank may need to monitor and report the gross exposure to connected counterparties against combined limits in addition to monitoring the exposure to each counterparty.

7.4. Role of governing body—concentration risk

(1) An Islamic bank’s governing body must ensure that an Islamic Bank’s concentration risk management policy gives an Islamic Bank a comprehensive firm-wide view of the significant sources of concentration risk (including on-balance-sheet exposures, offbalance-sheet exposures and exposures from contingent liabilities).

(2) The governing body must also ensure that an Islamic Bank’s senior management monitors the limits set in this Chapter and that those limits are not exceeded on a solo or consolidated basis.

7.5. Concentration risk

Concentration risk to an Islamic Bank arises if an Islamic Bank is exposed to 1 counterparty, or to 2 or more counterparties that are not truly independent of each other, and the total of the exposures to the counterparty or counterparties is large enough to endanger an Islamic Bank’s liquidity or solvency.

Guidance

Significant sources of concentration risk include:

i) concentration of exposures to a single counterparty or connected counterparties;

ii) concentration of exposures to counterparties in the same industry, sector, region or country; and

iii) concentration of exposures to counterparties whose financial performance depends on the same activity or commodity.

A concentration of exposures would also arise if a firm accepts collateral or credit protection provided by a single provider (because an Islamic Bank is exposed to the provider).

7.6. Policies—concentration risk sources and limits

(1) An Islamic bank’s concentration risk policy must set limits for acceptable concentrations of risk, consistent with an Islamic Bank’s risk tolerance, risk profile and Capital. The limits must be made known to, and must be understood by, all relevant staff.

(2) The policy must require that:

• (a) an Islamic Bank’s information systems identify exposures creating risk concentrations and large exposures to single counterparties or connected counterparties, aggregate those exposures and facilitate their management; and
• (b) all significant such concentrations and exposures are reviewed regularly and reported to an Islamic Bank’s governing body or senior management.

Guidance

An Islamic bank’s policies should be flexible to help an Islamic Bank to identify risk concentrations. To achieve this, the systems should be capable of analysing an Islamic Bank’s credit portfolio by:

• (a) size of exposure
• (b) exposure to connected counterparties
• (c) product
• (d) geography
• (e) industry or sector (for example, manufacturing and industrial)
• (f) account performance
• (g) internal credit risk assessment
• (h) funding
• (i) outstandings versus commitments
• (j) types and coverage of collateral.

7.7. Relation to stress-testing

When carrying out stress-testing or review of stress scenarios, an Islamic Bank must take into account significant risk concentrations and large exposures, and the effects of changes in market conditions and risk factors on them.

7.8. Large Exposures

(1) Large Exposure means a gross exposure to a counterparty or connected counterparties that is 10% or more of an Islamic bank’s Regulatory Capital.

(2) In this rule, gross exposure to a counterparty or connected counterparties is the total of the following exposures:

• (a) on-balance-sheet and off-balance-sheet exposures;
• (b) debt securities held by an Islamic Bank;
• (c) equity exposures.

(3) In calculating the gross exposure, include:

• (a) the outstanding balances of all loans and advances;
• (b) holdings of debt or equity securities;
• (c) unused advised off-balance-sheet commitments, whether revocable or irrevocable; and
• (d) the credit equivalent amounts of all market-related transactions.

(4) However, in calculating the gross exposure, do not include:

• (a) claims, equity investments and other exposures deducted from an Islamic Bank’s Capital;
• (b) exposures to the extent that they are secured by cash collateral, if the criteria applicable to transactions collateralised by cash are satisfied;
• (c) exposures to the extent that they are guaranteed by (or secured against securities issued by) the AIFC, the National Bank of Kazakhstan, or another state or central bank that has a zero per cent risk-weight;
• (d) exposures arising in the course of settlement of market-related contracts; and
• (e) exposures to the extent that they have been written off or specifically provided for.

7.9. Policies - Large Exposures

An Islamic bank’s Large Exposure policy must include:

• (a) exposure limits, commensurate with an Islamic Bank’s risk tolerance, risk profile and Capital, for:
• (i) categories of counterparties (for example, sovereigns, other authorised firms and other financial entities, corporate and individual borrowers);
• (ii) connected counterparties;
• (iii) particular industries or sectors;
• (iv) particular countries; and
• (v) asset classes (for example, property holdings);
• (b) the circumstances in which the exposure limits may be exceeded;
• (c) the procedures for approving exceptions to, and deviations from, exposure limits or policies; and
• (d) the procedures for identifying, measuring, managing and reporting large exposures.

7.10. Limits on exposures—general

(1) An Islamic Bank must not become exposed without limit to a single counterparty. An Islamic Bank must not give a general guarantee of the obligations of a counterparty.

(2) An Islamic Bank may apply to the AFSA for approval for a proposed exposure in excess of the limits set out in this Chapter. An approval will be granted only in exceptional circumstances and only after an Islamic Bank satisfies the AFSA that the proposed exposure does not expose an Islamic Bank to excessive risk.

(3) The AFSA may impose a higher Regulatory Capital ratio on an Islamic Bank to compensate for the additional risk associated with the proposed exposure.

7.11. Limits on exposure—Islamic Bank

(1) An Islamic Bank must not have an exposure to a counterparty or to connected counterparties that exceeds any 1 of the following percentages of its Regulatory Capital:

• (a) 25% if financed by either its Regulatory Capital or funds raised through UPSIAs;
• (b) 40% if financed by the total of its Regulatory Capital and funds raised through UPSIAs.

(2) The sum of an Islamic bank’s non-exempt Large Exposures must not exceed 800% of its Regulatory Capital for exposures financed by its on-balance sheet sources of funding and Regulatory Capital.

(3) The Islamic Bank must monitor and control its exposures financed by its on-balance sheet sources of funding and Regulatory Capital on a daily basis to ensure that they remain within the concentration risk limits.

Guidance

(1) This rule sets specific large exposure limits for assets financed by Shari’ah-compliant sources. The AFSA uses these limits to provide constraints on the amount of concentration risk to which an Islamic Bank is exposed in respect of its holdings.

(2) An Islamic Bank has a large exposure if its fund holders’ or account holders’ credit exposure to a single counterparty or issuer, or connected counterparties or issuers, is large in relation to an Islamic Bank’s regulatory Capital. If exposure to a counterparty or issuer is large, the holders risk a large loss should the counterparty or issuer default.

7.12. Obligation to measure

(1) An Islamic Bank must measure, classify and make provision for each large exposure individually.

(2) An Islamic Bank must immediately notify the AFSA if an Islamic Bank is concerned that risk concentrations or large exposures might significantly affect its Capital adequacy. The notice must describe an Islamic Bank’s proposed measures to address its concerns.

7.13. Powers of AFSA

(1) If the AFSA considers it necessary or desirable to do so in the interest of effective supervision of an Islamic Bank, the AFSA may direct an Islamic Bank to treat a party as connected to another party.

(2) Despite anything in these rules, the AFSA may, in writing, set specific limits on an Islamic bank’s exposures to particular counterparties, groups of counterparties, industries, sectors, regions, countries or asset classes on a case-by-case basis.

(3) If an Islamic Bank has 1 or more large exposures (excluding exposures to sovereigns and central banks) or if, in the AFSA’s opinion, an Islamic Bank is exposed to a significant level of risk concentration, the AFSA may impose a higher Capital ratio on an Islamic Bank.

(4) In considering whether to increase an Islamic Bank’s Capital ratio, the AFSA will take into account:

• (a) whether the increased Capital ratio would be consistent with an Islamic Bank’s concentration risk and large exposure policies;
• (b) the number of exposures, and the size and nature of each; and
• (c) the nature, scale and complexity of an Islamic Bank’s business and the experience of its governing body and senior management.

(5) The AFSA may also direct an Islamic Bank to take measures to reduce its level of risk concentration.