8. MARKET RISK

8.1. General

(1) This Chapter sets out the requirements for an Islamic bank’s market risk management policy to identify, measure, evaluate, manage and control or mitigate market risk. This Chapter also sets out how to calculate an Islamic Bank’s market risk Capital requirement.

(2) An Islamic Bank that operates in a market incurs risks from potential movements in market prices.

(3) In calculating its Capital requirement, an Islamic Bank must take into account unexpected losses that may arise from the market risk exposures it faces.

(4) In determining the value of an asset or liability, an Islamic Bank must also make appropriate adjustments for uncertainties arising from market risk.

8.2. Role of governing body—market risk

An Islamic bank’s governing body must ensure that its market risk management policy gives an Islamic Bank a comprehensive firm-wide view of its market risk exposure and takes into account the risk of a significant deterioration in market liquidity.

8.3. Relation to stress-testing

When carrying out stress-testing or review of stress scenarios, an Islamic Bank must take into account market risk exposures.

8.4. Requirements—Capital and management of market risk

(1) An Islamic bank’s trading book consists of the positions held by an Islamic Bank (whether on-balance-sheet or off-balance-sheet) that must be included in the book in accordance with these rules. Other positions held by an Islamic Bank must be included in its banking book.

(2) An Islamic Bank must have a trading book if:

(a) it has positions that must be included in the trading book; and
(b) the total value of the positions described in paragraph (a) has exceeded 5% of the total of an Islamic Bank’s on-balance-sheet and off balance-sheet positions at any time in the previous 12 months.

(3) An Islamic Bank must include, in the trading book, trading positions and exposures of the following kinds:

(a) a position taken to hedge an exposure in the trading book, using Shari’ah-compliant hedging instruments;
(b) a principal broking position in a financial instrument, commodity or commodity Shari’ah-compliant hedging instrument;
(c) an exposure from a repurchase agreement, or securities or commodities lending, that is based on a position in a security or commodity included in the trading book;
(d) an exposure from a reverse repurchase agreement, or securities and commodities borrowing, that is based on a position in a security or commodity included in the trading book;
(e) an exposure from an unsettled transaction, a free delivery or an OTC Shari’ahcompliant hedging instrument;
(f) an exposure in the form of a fee, commission, interest, dividend or margin on an exchange-traded Shari’ah-compliant hedging instrument directly related to a position included in the trading book.

(4) An Islamic Bank must also include in its trading book:

(a) total-rate-of-return swaps (except those that have been transacted to hedge a banking book credit exposure); and
(b) open short positions in Shari’ah-compliant hedging instruments.

(5) An Islamic Bank must not include in its trading book:

(a) positions held for liquidity management; and
(b) loans (unless they are used to hedge a position or transaction in the trading book).

(6) Trading position, of an Islamic Bank, means a position that is held:

(a) for short-term resale;
(b) with the intent of benefiting from actual or expected short-term price movements; or
(c) to lock in arbitrage profits.

Guidance

Whenever an Islamic Bank acts as principal (even in the course of an activity normally described as ‘broking’ or ‘customer business’), the resulting positions should be included in the trading book. This applies even if the nature of the business means that the only risks being incurred by an Islamic Bank are counterparty risks (that is, no market risk Capital requirements apply).

8.5. Trading Book

(2) An Islamic Bank must have a trading book if:

(a) it has positions that must be included in the trading book; and
(b) the total value of the positions described in paragraph (a) has exceeded 5% of the total of an Islamic Bank’s on-balance-sheet and off balance-sheet positions at any time in the previous 12 months.

(3) An Islamic Bank must include, in the trading book, trading positions and exposures of the following kinds:

(a) a position taken to hedge an exposure in the trading book, using Shari’ah-compliant hedging instruments;
(b) a principal broking position in a financial instrument, commodity or commodity Shari’ah-compliant hedging instrument;
(c) an exposure from a repurchase agreement, or securities or commodities lending, that is based on a position in a security or commodity included in the trading book;
(d) an exposure from a reverse repurchase agreement, or securities and commodities borrowing, that is based on a position in a security or commodity included in the trading book;
(e) an exposure from an unsettled transaction, a free delivery or an OTC Shari’ahcompliant hedging instrument;
(f) an exposure in the form of a fee, commission, interest, dividend or margin on an exchange-traded Shari’ah-compliant hedging instrument directly related to a position included in the trading book.

(4) An Islamic Bank must also include in its trading book:

(a) total-rate-of-return swaps (except those that have been transacted to hedge a banking book credit exposure); and
(b) open short positions in Shari’ah-compliant hedging instruments.

(5) An Islamic Bank must not include in its trading book:

(a) positions held for liquidity management; and
(b) loans (unless they are used to hedge a position or transaction in the trading book).

(6) Trading position, of an Islamic Bank, means a position that is held:

(a) for short-term resale;
(b) with the intent of benefiting from actual or expected short-term price movements; or
(c) to lock in arbitrage profits.

Guidance

8.6. No switching of instruments between books

(1) An Islamic Bank must not switch an instrument between its trading book and banking book, unless the AFSA has, in writing, allowed an Islamic Bank to do so. The AFSA may approve a switch subject to 1 or more conditions.

(2) An Islamic Bank must not benefit from any lower Regulatory Capital requirement resulting from a switch approved by the AFSA.

Guidance

The AFSA will grant approval to switch exposures or positions between banking and trading books only in extraordinary cases and in such cases, the Islamic Bank will be required to publicly disclose the switch.

8.7. Market Risk Management Policy

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

(a) effective systems for the accurate and timely identification, measurement, evaluation, management and control or mitigation of market risk, and reporting to an Islamic Bank’s governing body and senior management;
(b) prudent and appropriate market risk limits that are consistent with an Islamic Bank’s risk tolerance, risk profile and Capital, and with the management’s ability to manage;
(c) who is responsible for identifying, measuring and reporting market risk;
(d) procedures for tracking and reporting exceptions to, and deviations from, limits or policies; and
(e) procedures for including positions and exposures in the trading book.

(2) The policy must ensure that all of an Islamic Bank’s transactions are identified and recorded in a timely way and that their valuations are consistent and prudent.

8.8. Trading Book Policies

(1) An Islamic Bank that is required to have a trading book must have clearly defined policies for keeping the book up-to-date and the positions and exposures accurate.

(2) In particular, an Islamic Bank must have policies on:

(a) what to include, or not include, in the trading book;
(b) managing and reporting trading positions;
(c) valuing positions, including:
(i) clear definitions of the responsibilities of staff involved in the valuation;
(ii) sources of market information, and review of their reliability;
(iii) frequency of independent valuations;
(iv) timing of closing prices;
(v) procedures for adjusting valuations between periods;
(vi) ad-hoc verification procedures; and
(vii) reporting lines for the valuation function that are independent of the function that gave rise to the position.

(3) The policies must be approved by an Islamic Bank’s governing body, and an Islamic Bank must be able to demonstrate compliance with them if directed by the AFSA.

(4) An Islamic Bank must also have adequate policies:

(a) to monitor compliance with the policies and distinguish consistently between trading activities and banking activities;
(b) to deal with legal, regulatory or operational restrictions on immediate liquidation of exposures; and
(c) to monitor the size of its trading book.

8.9. Measurement of market risk - Standard method

(1) An Islamic Bank must use the standard method for measuring market risk unless the AFSA has approved the use of an internal model for the same purpose. The standard method comprises a range of approaches that a firm may use to calculate market risk capital requirement from its trading activities.

(2) In the standard method, market risk Capital requirement is the sum of the capital charges for:

(a) foreign exchange risk in the trading book and banking book;
(b) options risk in the trading book and banking book;
(c) commodities risk in the trading book and banking book;
(d) inventory risk in the trading book and banking book;
(e) traded equity position risk; and
(f) traded profit rate risk on sukuk and other Shari’a-compliant debt securities and profit-rate-related instruments.

8.10. Valuing positions—mark-to-market

(1) An Islamic Bank must use the mark-to-market method to value its positions and exposures if there is a market to mark the positions and exposures to. Mark-to-market means a valuation that is based on current market value.

(2) The AFSA would expect an Islamic Bank to mark-to-market listed securities since there is a market with observable and reliable prices for such securities.

(3) A position that is marked-to-market must be revalued daily, based on independently sourced current market prices.

Guidance

(i) Because of the less liquid nature of many sukuk and equity positions held by an Islamic Bank, it is important for an Islamic Bank to have prudent valuation practices.

(ii) An Islamic Bank should mark-to-market as much as possible. It should use the prudent side of a bid or offer unless an Islamic Bank is a significant market maker that can close at mid-market.
(iii) When estimating fair value, an Islamic Bank should maximise the use of relevant observable inputs and avoid the use of unobservable inputs.

8.11. Valuing positions—mark-to-model

(1) If it is not possible to mark-to-market (for example, in the case of unlisted securities or where the market is inactive), an Islamic Bank may use the mark-to-model method to value its positions and exposures. Mark-to-model means a valuation that has to be benchmarked, extrapolated or otherwise calculated from a market input.

(2) An Islamic Bank must be able to demonstrate that its marking-to-model is prudent.

Guidance

An Islamic Bank should be extra conservative when marking-to-model. The AFSA will take into account the following in deciding if an Islamic Bank’s model is prudent:

(a) whether senior management is aware of the positions and exposures that are marked to model and whether it understands the uncertainty this might create in reporting the risk or performance of the business

(b) the extent to which market inputs are sourced from market prices

(d) the availability of generally accepted valuation methods for particular products

(e) who developed the model

(f) whether an Islamic Bank holds a secure copy of the model

(g) the existence of formal control procedures for changing the model

(h) how often the model is used to check valuations

(i) how aware is an Islamic Bank’s risk management function of the weaknesses of the model and how those weaknesses are reflected in the valuation output

(j) the results of comparisons between actual close out values and model outputs

(k) an Islamic Bank’s procedures for reviewing the model.

8.12. Independent price verification

An Islamic Bank must independently verify market prices and model inputs, to check that those prices and inputs are accurate. The verification must be done at least once a month.

Guidance

i) Independent price verification is different from daily mark-to-market. The object of the verification is to regularly check the accuracy of market prices or model inputs and, thereby, eliminate inaccurate daily marks. The verification should be carried out by a unit independent of whoever marked the positions or exposures.

ii) The independent marking in the verification process should reveal any error or bias in pricing. It entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates.

8.13. Valuation adjustments

(1) An Islamic Bank must consider making adjustments for positions that cannot be prudently valued (such as those that have become concentrated, less liquid or stale). For example, valuation adjustment would be appropriate if pricing sources are more subjective (such as when there is only one available broker quote).

(2) An Islamic Bank must establish and maintain procedures for considering valuation adjustments. This rule applies whether:

(a) an Islamic Bank uses the mark-to-market or mark-to-model method; and
(b) whether the valuation is done by an Islamic Bank itself or a third party.

(3) An Islamic Bank must consider the following valuation adjustments:

(a) unearned profit;
(b) close-out costs;
(c) operational risks;
(d) early termination;
(e) investing and funding costs;
(f) future administrative costs;
(g) model risk, if relevant;
(h) any other adjustment that an Islamic Bank considers appropriate.

8.14. Foreign exchange risk

(1) In measuring its market risk, an Islamic Bank must include the risk of holding or taking positions in foreign currencies, gold and silver (exchange risk). Foreign exchange risk may arise from an Islamic Bank’s trading in the foreign exchange market and other markets; it may also arise from non-trading activities that are denominated in a foreign currency.

(2) If an Islamic Bank is exposed to profit rate risk on positions in foreign currencies, gold and silver, an Islamic Bank must include the relevant profit rate positions in the calculation of profit rate risk in the trading book.

(3) Silver and gold are treated under Shari’ah as foreign exchange positions (rather than as commodity positions.

(4) If foreign currency is to be received or delivered under a binding unilateral promise, an Islamic Bank must report any profit rate exposure from the other leg of the contract in accordance with Rule 8.43 (profit rate risk in the trading book).

(5) If gold or silver is to be received or delivered under a binding unilateral promise, an Islamic Bank must report any foreign currency or profit rate exposure from the other leg of the contract in accordance with this Part or Part 8.43, as the case requires.

8.15. What to include in foreign exchange risk

(1) In calculating the Capital charge for foreign exchange risk, an Islamic Bank must include in its exposure to each foreign currency:

(a) the net spot position (that is, assets minus liabilities denominated in the currency, including accrued profit and other accrued income and accrued expenses);
(b) the net position of binding unilateral promises by an Islamic Bank to buy or sell currencies on a specified future date (that are not included in the spot position);

Examples of amounts to be received or paid

(i) the principal on currency swaps not included in the spot position
(ii) profit from swaps and other profit rate transactions.
(c) irrevocable guarantees (and similar instruments) that are certain to be called and likely to be irrecoverable; and
(d) any other items representing an exposure to risk in foreign currencies (for example a specific provision held in the currency in question where the underlying asset is held in a different currency).

(2) An Islamic Bank may also include in its currency exposure any net future income or expenses that are not yet accrued but already fully hedged. If an Islamic Bank includes such income or expenses, it must do so consistently and must not select only expected future flows that reduce its position.

(3) If an Islamic Bank has deliberately taken a position to partly or totally protect itself against the adverse effect of a change in an exchange rate on its Capital adequacy ratio, it may exclude the position from its currency exposure insofar as it relates to that hedge, if:

(a) the position is of a structural and non-trading nature;
(b) the structural position does no more than protect an Islamic Bank’s Capital adequacy ratio;
(c) the position cannot be traded for speculative or profit-making purposes; and
(d) the exclusion of the position is done consistently, with the treatment of the hedge remaining the same for the life of the assets or other items.

(4) A structural position includes:

(a) a position arising from an instrument that satisfies the criteria for inclusion as Capital under Chapter 4 of this Rules;
(b) a position in relation to a net investment in a self-sustaining subsidiary, the accounting consequence of which is to reduce or eliminate what would otherwise be a movement in the foreign currency translation reserve; and
(c) an investment in an overseas subsidiary or other entity in the same corporate group as an Islamic Bank that, under these rules, is deducted from an Islamic Bank’s Capital for Capital adequacy purposes.

(5) An Islamic Bank must also include any currency exposures arising from equity, commodity and profit rate positions.

8.16. Foreign exchange risk on consolidated basis

(1) If an Islamic Bank is assessing its foreign exchange risk on a consolidated basis and it is technically impractical for a marginal operation to include the currency positions of an overseas branch or subsidiary of an Islamic Bank, the internal limit in each currency applied to the overseas branch or subsidiary may be used as a proxy for the positions. Marginal operation, in relation to a firm, is an operation of an Islamic Bank that accounts for less than 5% of an Islamic Bank’s total currency positions.

(2) The absolute values of the limits must be added to the net open position in each currency, but only if the actual positions are adequately monitored against those internal limits.

8.17. Capital charge—foreign exchange risk

(1) For an Islamic Bank that does not write options, net open position in a foreign currency is the sum of:

(a) an Islamic Bank’s currency exposures under rule 8.15 for the currency; and
(b) the value of the options and their associated underlying assets measured using the simplified approach.

(2) For an Islamic Bank that writes options, net open position in a foreign currency is the sum

of:

(a) an Islamic Bank’s currency exposures under rule 8.15 for the currency; and
(b) either:
(i) the net delta-based equivalent of an Islamic Bank’s total book of foreign currency options (with separately calculated Capital charges for gamma risk and vega risk under Delta-plus method); or
(ii) the value of the options and their associated underlying assets under the deltaplus method under Delta-plus method.

(3) An Islamic Bank must calculate its overall foreign currency net open position by:

(a) calculating the net open position in each foreign currency;
(b) converting the nominal amount (or net present value) of each such net position into US Dollar at the current spot market exchange rate;
(c) adding all short net positions and adding all long net positions calculated under paragraphs (a) and (b); and
(d) selecting the greater of the absolute values of the 2 sums in paragraph (c).

(4) An Islamic Bank must then calculate its net position in gold and silver by:

(a) valuing all gold and silver positions using the US dollar current spot price (regardless of maturity);
(b) offsetting long and short positions; and
(c) converting the absolute value of the resulting net position into US Dollar.

(5) To convert the net position in gold and silver into US Dollar, an Islamic Bank must state the position (spot plus forward) in a standard unit of measurement and then convert the net position at the current spot market exchange rate.

(6) The Capital charge for foreign exchange risk of an Islamic Bank is the sum of:

(a) 8% of an Islamic Bank’s overall foreign currency net open position in each of the foreign currencies it holds; and
(b) 8% of its net position in gold and silver.

8.18. Valuing positions—binding unilateral promises

An Islamic Bank must value net positions of binding unilateral promises in foreign exchange transactions, gold and silver at the current spot market exchange rates.

8.19. Options risk

In measuring its market risk, an Islamic Bank must include the risk of holding or taking positions in options contracts (options risk).

8.20. Measuring options risk

(1) An Islamic Bank that does not write options must use the simplified approach.

(2) An Islamic Bank that writes options must use the delta-plus method.

8.21. Using simplified approach

An Islamic Bank that does not write options must calculate Capital charges in accordance with:

(a) rule 8.22 for a position that is a ‘long cash and long put’ or ‘short cash and long call’ position; or
(b) rule 8.23 for a position that is a ‘long put’ or ‘long call’ position.

Guidance

In the simplified approach, the position in the option and the associated underlying asset (cash or forward) is not subject to the mark-to-market method. Instead, each position is carved-out and is subject to a separately calculated Capital charge for specific risk and general risk.

8.22. Capital charges—‘long cash and long put’ or ‘short cash and long call’

(1) For a position that is ‘long cash and long put’ or ‘short cash and long call’, the Capital charge is calculated by multiplying the market value of the underlying security by the sum of the specific and general risk Capital charges for the underlying, and then subtracting the amount by which the option is in-the-money (bounded at zero).

(2) In the simplified approach, the Capital charge is:

(a) 8% for options on currency; and
(b) 15% for options on commodities.

(3) For options with a residual maturity of less than 6 months, an Islamic Bank must use the forward price (instead of the spot price) if it is able to do so.

(4) For options with a residual maturity of more than 6 months, an Islamic Bank must compare the strike price with the forward price (instead of the current price). If an Islamic Bank is unable to do this, it must take the in-the-money amount to be zero.

Guidance

i) In cases (such as foreign exchange transactions) where it is unclear which side is the underlying security, the underlying should be taken to be the asset that would be received if the option were exercised. In addition, the nominal value should be used for items if the market value of the underlying instrument could be zero (such as in caps, floors and swaptions).

ii) Some options have no specific risk (such as those having a profit rate, currency or commodity as the underlying security); other options on profit-rate-related instruments and options on equities and stock indices, however, would have specific risk.

8.23. Capital charges—‘long put’ or ‘long call’

(1) For a position that is ‘long put’ or ‘long call’, the Capital charge is the lesser of:

(a) the market value of the underlying security multiplied by the sum of the specific and general risk Capital charges for the underlying; and
(b) the market value of the option.

(2) In respect of (1)(b) above, the book value of the option may be used instead of the market value if the position is not included in the trading book (for example, options on particular foreign exchange or commodities positions).

8.24. Using delta-plus method

(1) An Islamic Bank that writes options must calculate specific risk Capital charges separately by multiplying the delta-equivalent value of each option by the risk-weight applicable under equity position risk and profit rate risk in the trading book.

(2) In calculating general risk Capital charge, an Islamic Bank must enter delta-weighted positions with a debt security or profit rate as the underlying into the profit rate time bands in table 8.50 A by using a two-legged approach. Under this approach, there is 1 entry at the time the underlying contract takes effect and a second entry at the time the underlying contract matures.

(3) For an option with a debt security as the underlying, an Islamic Bank must apply a specific risk Capital charge to the delta-weighted position based on the issuer’s rating and in accordance with the rules on measuring profit rate risk – Rule 8.43.

8.25. Relation to mark-to-market method

(1) An Islamic Bank that writes options must include delta-weighted option positions in measuring its market risk.

(2) An Islamic Bank must report such an option as a position equal to the sum of the market values of the underlying multiplied by the sum of the absolute values of the deltas. Because delta does not cover all risks associated with option positions, an Islamic Bank must calculate gamma and vega in calculating the regulatory Capital charge.

(3) An Islamic Bank must calculate delta, gamma and vega using the pricing model used by a recognised exchange, or a proprietary options pricing model approved, in writing, by the AFSA.

8.26. Capital charges—options

(1) The Capital charge for an option with equities as the underlying must be based on the delta-weighted positions included in the measurement of specific and general risks in accordance with Rules for Inventory risk (equity position risk).

(2) An Islamic Bank that writes options must calculate the Capital charge for options on foreign exchange and gold and silver positions in accordance with rules for foreign exchange risk. For delta risk, the net delta-based equivalent of the foreign currency, gold and silver options must be included in the measurement of the exposure for the respective currency, gold or silver position.

(3) The Capital charge for an option on commodities must be based on the charge calculated using the simplified approach in Rule 8.21.

8.27. Gamma Capital charges

(1) An Islamic Bank that writes options must calculate the Capital charge for gamma risk (gamma Capital charge) for each option position separately.

(2) To calculate gamma Capital charge, calculate the gamma impact of each option in accordance with the following formula:

where:

Gamma impact = × gamma × VU²

VU is:

(a) for a profit rate option:

(i) if the option has a bond as the underlying—the market value of the underlying multiplied by the risk factor applicable under column 3 of table 8.50 A; or
(ii) if the option has a profit rate as the underlying—the market value of the underlying multiplied by the assumed changes in yield in column 4 of table 8.50 A;

(b) for options on equities and stock indices—the market value of the underlying multiplied by 8%;

(d) for an option on commodities—the market value of the underlying multiplied by 15%.

(3) In calculating the gamma impact for an option mentioned in the definition of VU, an Islamic Bank must treat as the same underlying:

(a) for profit rates—each time band in column 2 of table 8.50 A (with each position allocated to separate maturity ladders);

(b) for equities and stock indices—each recognised exchange;

(d) for commodities—each individual commodity of a kind described in Rule 8.29.

(4) Each option on the same underlying described in sub-rules (2) and (3) will have a gamma impact that is positive or negative. An Islamic Bank must add the individual gamma impacts, resulting in a net gamma impact for each underlying that is either positive or negative.

(5) To calculate an Islamic Bank’s total gamma Capital charge, exclude gamma impacts that are positive. The total gamma Capital charge is the sum of the absolute values of the net negative gamma impacts.

8.28. Vega Capital charges

(1) An Islamic Bank that writes options must calculate the Capital charge for vega risk (vega Capital charge) for each option position separately.

(2) To calculate vega Capital charge, an Islamic Bank must multiply the vega for each option mentioned in the definition of VU in Rule 8.27 (2) by a 25% proportional shift in the option’s current volatility. The results must then be summed across each underlying.

(3) The total vega Capital charge is the sum of the absolute values of the vega Capital charges across each underlying.

8.29. Commodities risk and inventory risk

(1) In measuring its market risk, an Islamic Bank must include the risk of holding or taking positions in commodities and commodities options (commodities risk).

(2) Commodities means physical or energy products that may be traded. Commodities include precious metals (other than gold and silver), base metals, agricultural products, minerals, oil, gas and electricity.

(3) If an Islamic Bank is exposed to foreign exchange or profit rate risk from funding commodities positions, an Islamic Bank must include the relevant positions in the measurement of foreign exchange risk and profit rate risk in the trading book—see Rules 8.17 and 8.43, respectively.

(4) Unlike Basel II, silver and gold are treated under Shari’ah as foreign exchange positions (rather than as commodity positions). In Basel II, only gold is treated in that way.

(5) If a commodity is to be received or delivered under a binding unilateral promise, an Islamic Bank must report any foreign currency, equity or profit rate exposure from the other leg of the contract in accordance with Rules under Inventory risk, as the case requires.

8.30. Measuring commodities risk

(1) An Islamic Bank must use the simplified approach to measure commodities risk.

(2) To calculate open positions using this approach, an Islamic Bank may report short and long positions in each commodity on a net basis. Positions are reported on a net basis by offsetting them against each other in accordance with sub-rule (3).

(3) Positions in the same commodity may be offset. Positions in different commodities must not be offset unless:

(a) the positions are deliverable against each other; or
(b) the positions are in commodities which are close substitutes for each other and a minimum correlation between price movements of 0.9 can be clearly established over at least the preceding year.

(4) An Islamic Bank must not use the correlation-based offsetting mentioned in paragraph (b) unless the AFSA has, in writing, allowed an Islamic Bank to use it.

8.31. Measuring net positions

An Islamic Bank must first state each commodity position (spot plus forward) in terms of the standard unit of measurement for the commodity (such as barrels, kilos or grams). An Islamic Bank must then convert the net position in each commodity into US Dollar at the current spot market exchange rates.

8.32. What to include in commodities risk

(1) In calculating the Capital charge for commodities risk, an Islamic Bank must include commodity Shari’ah-compliant hedging instruments and off-balance-sheet positions that are affected by changes in commodity prices (such commodity swaps). An Islamic Bank must include commodities risk arising from salam contracts.

(2) Options on commodities for which the options risk is measured using the delta-plus method must also be included (with their underlying assets). Options for which the options risk is measured using the simplified approach must be excluded.

(3) An Islamic Bank must convert commodity Shari’ah-compliant hedging instruments into notional commodities positions and assign them to maturities under rule 8.33.

8.33. Assigning notional positions to maturities

Binding unilateral promises relating to a particular commodity must be included in the measurement of commodities risk as notional amounts in terms of the standard unit of measurement multiplied by the spot price of the commodity.

8.34. Capital charges—simplified approach

(1) The Capital charge for commodities risk of an Islamic Bank is the sum of:

(a) 15% on an Islamic Bank’s overall net position, long or short, in each commodity; and
(b) 3% on an Islamic Bank’s gross position in each commodity.

(2) Gross position, of a firm in a commodity, is the sum of the absolute values of all short positions and all long positions of an Islamic Bank, regardless of maturity.

(3) An Islamic Bank must use the current spot price to calculate its gross position in commodity Shari’ah-compliant hedging instruments.

8.35. Relation to market risk

In measuring its market risk, an Islamic Bank must include the risk of holding assets in inventory with a view to reselling them under a murabahah contract or for leasing them under an ijarah contract (inventory risk).

8.36. Measuring inventory risk

(1) An Islamic Bank must use the simplified approach to measure inventory risk.

(2) The Capital charge for inventory risk of an Islamic Bank is 15% of the value of the assets held by an Islamic Bank in inventory with a view to resale or lease.

8.37. Equity position risk

(1) In measuring its market risk, an Islamic Bank must include the risk of holding or taking positions in equities (equity position risk).

(2) If equities are to be received or delivered under a binding unilateral promise, an Islamic Bank must report any foreign currency or profit rate exposure from the other leg of the contract in accordance with Rules for currency exposures or the Rules addressing profit rate exposures, as the case requires.

(3) If an Islamic Bank is exposed to profit rate risk on equity positions, an Islamic Bank must include the relevant profit rate positions in the calculation of profit rate risk in the trading book.

8.38. Measuring equity position risk

(1) The measurement of equity position risk in the trading book applies to short and long positions in all instruments that exhibit market behaviour similar to equities.

Examples of instruments with equity-like behaviour

(i) common shares (whether voting or non-voting)

(ii) investments in Islamic collective investment schemes
(iii) convertible securities and commitments to buy or sell equity securities
(iv) convertible bonds that trade like equities.

(2) An Islamic Bank may report short and long positions in instruments relating to the same issuer on a net basis.

(3) An Islamic Bank must calculate the long or short position in the equity market on a marketby-market basis. That is, an Islamic Bank must make a separate Capital calculation for each exchange in which it holds equities (whether or not a recognised exchange).

8.39. What to include in equity position risk

(1) In calculating the Capital charge for equity position risk, an Islamic Bank must include equity Shari’ah-compliant hedging instruments and off-balance-sheet positions that are affected by changes in equity prices.

(2) To calculate the charges for equity position risk for equity Shari’ah-compliant hedging instruments and other off-balance-sheet positions, an Islamic Bank must convert positions into notional equity positions, so that:

(a) equity Shari’ah-compliant hedging instruments and off-balance-sheet positions relating to individual equities are reported at current market prices;
(b) equity Shari’ah-compliant hedging instruments and off-balance-sheet positions relating to stock indices are reported as the mark-to-market value of the notional underlying equity portfolio; and
(c) equity swaps are treated as 2 notional positions.

8.40. Charges for specific and general risks

(1) The Capital charge for equity position risk consists of 2 separately calculated charges:

(a) a charge for the specific risk of holding a long or short position in an individual equity; and
(b) a charge for the general risk of holding a long or short position in the market as a whole.

(2) The Capital charge for specific risk is 8% on the gross position of an Islamic Bank in equities listed on a recognised exchange and 12% on the gross position of an Islamic Bank in other equities. Gross position, of a firm in an equity market, is the sum of the absolute values of all short equity positions and all long equity positions of an Islamic Bank.

(3) The Capital charge for general risk is 8% on the net position of an Islamic Bank. Net position, of a firm in an equity market, is the difference between long equity positions and short equity positions of an Islamic Bank.

(4) Equity position is the net of short and long exposures to an individual company. It is measured on the gross position across the company (rather than individual transactions).

8.41. Offsetting positions

(1) If an Islamic Bank takes a position in depository receipts against an opposite position in the underlying equity (whether or not listed in the same country where the receipts were issued), it may offset the positions only if any costs on conversion are taken into account in full.

(2) An Islamic Bank may offset matched positions in an identical equity or stock index in each market, resulting in a single net long or short position to which the specific and general risk Capital charges are to be applied. For this purpose, a future in an equity may be offset against an opposite physical position in the same equity.

8.42. Charges for index contracts

(1) For an index contract on an index that an Islamic Bank considers diversified, an Islamic Bank must apply a general risk Capital charge of 8%, and a specific risk Capital charge of 2%, to the net long or short position in the contract.

(2) For any other index contract, an Islamic Bank must apply a general risk Capital charge of 8%, and a specific risk Capital charge of 4%, to the net long or short position in the contract.

(3) If required to do so by the AFSA, an Islamic Bank must demonstrate why it considers an index to be a diversified index.

Guidance

An Islamic Bank should test diversification against the following criteria used by the European Banking Authority:

(i) The index must have a minimum number of equities. There must be an absolute threshold below which the index cannot be considered sufficiently diversified to ignore the specific risk completely.

(ii) None of the equities must significantly influence the volatility of the index. Equities must not represent more than a certain percentage of the total index value.
(iii) The index must have equities diversified from a geographical perspective.
(iv) The index must represent equities that are diversified from an economic perspective. Different ‘industries’ must be represented in the index.

8.43. Profit rate risk in the trading book

In measuring its market risk, an Islamic Bank must include the risk of holding or taking positions in sukuk and other Shari’ah-compliant debt securities and profit-rate-related instruments that are held in the trading book (profit rate risk in the trading book).

8.44. What to include in profit rate risk

(1) The measurement of profit rate risk in the trading book applies to all fixed-rate and floating-rate debt securities and other profit-rate related instruments that exhibit market behaviour similar to debt securities.

Examples

(i) fixed-rate and floating-rate sukuk

(ii) non-convertible preference shares
(iii) convertible sukuk that trade like debt securities.

(2) A debt security that is the subject of a repurchase or securities lending agreement is taken to be owned by the lender of the security.

(3) In calculating the Capital charge for profit rate risk in the trading book, an Islamic Bank must include profit rate exposures arising from binding unilateral promises in foreign exchange transactions and forward sales and purchases of commodities and equities.

(4) An Islamic Bank must also include any profit rate exposures arising from foreign exchange, commodity and equity positions.

8.45. Capital charge—profit rate risk

The Capital charge for profit rate risk in the trading book consists of 2 separately calculated charges:

(a) a charge for the specific risk of holding a long or short position in an individual instrument; and
(b) a charge for the general risk of holding a long or short position in the market as a whole.

Guidance

The Capital charge for general risk is for the risk of loss arising from changes in market profit rates.

8.46. Calculating specific risk Capital charge

(1) The Capital charge for specific risk arising from an on-balance-sheet or off-balance-sheet profit-rate position held in an Islamic Bank’s trading book is calculated by multiplying the market value of the debt security by the applicable charge set out in column 5 of table 8.46 A for the category and residual maturity of the instrument.

(2) An Islamic Bank can only offset matched long and short positions (including positions in Shari’ah-compliant hedging instruments) in identical instruments with exactly the same issuer, profit rate, currency and maturity.

Table 8.46 A Specific risk Capital charges

Item	Category	External Credit Rating	Residual Maturity	Specific Risk Capital Charge %
1	government	AAA to AA-		0.00
		A+ to BBB-	6 months or less more than 6 months and up to and including 24 months more than 24 months	0.25 1.00 1.60
		BB+ to B- or unrated		8.00
		Below B-		12.00
2	qualifying		6 months or less more than 6 months and up to and including 24 months more than 24 months	0.25 1.00 1.60
3	other	BB+ to BB- or unrated Below BB-		8.00 12.00

(3) In column 2 of table 8.46 A: government, as a category, includes all forms of government paper such as bonds, treasury bills and other short-term instruments. qualifying, as a category, includes:

(a) securities issued by public sector enterprises and multilateral development banks;
(b) instruments rated investment grade by at least 2 ECRAs;
(c) instruments rated investment grade by 1 ECRA and 1 other credit rating agency that is not an ECRA; and
(d) unrated instruments, but only if:
(i) an Islamic Bank has no reason to suspect that the particular instrument would have a rating less than investment grade if it were rated; and
(ii) the issuer of the instrument is rated investment grade and is regulated in its home jurisdiction in a way comparable to deposit-takers in the AIFC. other, as a category, includes:
(a) instruments issued or fully guaranteed by the central government or central bank of a state that is a member of the OECD;
(b) instruments fully collateralised by instruments described in paragraph (a); and
(c) instruments issued or fully guaranteed by the central government or central bankof a state that is not a member of the OECD, but only if:
(i) the instruments have a residual maturity of 1 year or less;
(ii) the instruments are denominated in the local currency of the issuer; and
(iii) an Islamic Bank’s holdings in such instruments are funded by liabilities in the same currency.

(4) In column 3 of table 8.46 A, external credit rating means a long-term rating issued by an ECRA for the purpose of risk-weighting claims on rated counterparties and exposures.

Guidance

Financial instruments issued by Kazakhstan (whether denominated in Kazakhstani tenge or not), or by other member states of the GCC, are risk-weighted at zero per cent. In deciding whether an issuer is regulated in a comparable way, an Islamic Bank must look, in particular, at the home jurisdiction’s risk-based Capital requirements and consolidated supervision.

8.47. Instruments that have no specific risk Capital charge

(1) Profit rate swaps, cross-currency swaps and binding unilateral promises in foreign exchange transactions are exempt from specific risk Capital charges. However, a specific risk Capital charge must be calculated if the underlying is a debt security or an index representing a basket of debt securities.

(2) Forward contracts and binding unilateral promises (other than those in foreign exchange transactions) are exempt from specific risk Capital charges if:

(a) the Islamic Bank has a right to substitute cash settlement for physical delivery under the contract; and
(b) the price on settlement is calculated with reference to a general market price indicator.

(3) A contract or promise that is exempt under (2) above must not be offset against specific securities (including those securities that make up the market index).

8.48. Measuring general risk

(1) General risk is measured using the maturity method. In that method, positions are allocated to a maturity ladder before the Capital charge is calculated.

(2) An Islamic Bank must add the absolute values of the individual net positions within each time band, whether long or short. The sum of the absolute values is an Islamic Bank’s gross position.

8.49. Maturity method

(1) In the maturity method, long or short positions in debt securities, Shari’ah-compliant hedging instruments and other sources of profit rate exposures are allocated to the time bands in table 8.50 A (and then to the zones in table 8.50 B) based on residual maturity and profit rate.

(2) An Islamic Bank must allocate:

(a) positions in fixed-rate instruments according to their residual term to maturity; and
(b) positions in floating-rate instruments according to the residual term to the next repricing date.

(3) An Islamic Bank may offset:

(a) long and short positions (whether actual or notional) in identical instruments with exactly the same issuer, profit rate, currency and maturity; and

(b) matched swaps and binding unilateral promises that satisfy the criteria in Rule 8.55.

8.50. Steps in calculating general risk Capital charge

The steps to calculate the general risk Capital charge are:

Step 1

Weight the positions in each time band by the risk factor corresponding to those positions in table 8.50 A.

Table 8.50 A Time Bands and risk factors

Item	Time Band	Risk Factor %	Assumed Changes In Yield, %
1	1 month or less	0.00	1.00
2	more than 1 and up to 3 months	0.20	1.00
3	more than 3 and up to 6 months	0.40	1.00
4	more than 6 and up to 12 months	0.70	1.00
5	more than 1 and up to 2 years	1.25	0.90
6	more than 2 and up to 3 years	1.75	0.80
7	more than 3 and up to 4 years	2.25	0.75
8	more than 4 and up to 5 years	2.75	0.75
9	more than 5 and up to 7 years	3.25	0.70
10	more than 7 and up to 10 years	3.75	0.65
11	more than 10 and up to 15 years	4.50	0.60
12	more than 15 years and up to 20 years	5.25	0.60
13	more than 20 years	6.00	0.60

Step 2

Offset the weighted long and short positions within each time band.

Example

If the sum of the weighted long positions in a time band is KZT100 million and the sum of the weighted short positions in the band is KZT90 million, you offset the positions to come up with a matched position of KZT90 million and unmatched position of KZT10 million.

Step 3

For each time band, apply a 10% Capital charge (vertical disallowance) on the matched position calculated in step 2.

Example

Continuing on from the example in step 2, apply the 10% on the KZT90 million matched position to come up with a KZT9 million vertical disallowance for the time band.

Step 4

For the unmatched positions calculated in step 2, carry out 2 further rounds of offsetting using the zones (made up of time bands) in table 8.50 B and apply the appropriate Capital charge, as follows:

(a) first between the remaining unmatched positions within each of 3 zones and subject to a charge (expressed as a percentage) as follows:

(i) matched weighted positions within zone 1 x 40%;
(ii) matched weighted positions within zone 2 x 30%;
(iii) matched weighted positions within zone 3 x 30%;

(b) subsequently between the remaining unmatched positions across the 3 different zones (in the order set out below) and subject to a Capital charge as follows:

(i) matched weighted positions between zones 1 and 2 x 40%;
(ii) matched weighted positions between zones 2 and 3 x 40%;
(iii) matched weighted positions between zones 1 and 3 x 100%.

The absolute value of the net amount remaining is the net position.

Table 8.50 B Zones for profit rate

Item	Zone	Time Bands
1	zone 1	0 – 1 month 1 – 3 months 3 – 6 months 6 – 12 months
2	zone 2	1 – 2 years 2 – 3 years 3 – 4 years
3	zone 3	4 – 5 years 5 – 7 years 7 – 10 years 10 – 15 years 15 – 20 years more than 20 years

Step 5

Calculate the horizontal allowance by adding the charges from paragraphs (a) and (b) of step 4.

Step 6

Calculate the general risk Capital charge as the sum of:

(a) the net position calculated from steps 1 to 4;
(b) the vertical disallowance from step 3;
(c) the horizontal disallowance from steps 4 and 5; and
(d) the net charge for positions in options, where appropriate, calculated in accordance with Rule 8.19.

8.51. Positions in currencies

(1) An Islamic Bank must use separate maturity ladders for positions in each currency, with Capital charges calculated separately for each currency and then summed. Positions in different currencies are not to be offset.

(2) If an Islamic Bank’s position in a currency is less than 5% of the value of an Islamic Bank’s banking book assets, that currency is taken to be a residual currency and an Islamic Bank may use a single maturity ladder for all residual currencies (instead of having to use separate maturity ladders for each currency). An Islamic Bank must enter, into each appropriate time band, the net long or short position for residual currencies.

(3) An Islamic Bank must apply, with no further offsets, the risk factor in column 3 of table 8.50 A to the position in each time band for residual currencies.

8.52. Binding unilateral promises

(1) An Islamic Bank must treat a binding unilateral promise on bank or corporate debt as a long position or a short position in the underlying debt security. A binding unilateral promise that is not on bank or corporate debt must be treated as a long position or a short position in a notional government security.

(2) If a range of instruments may be delivered to fulfil a contract, an Islamic Bank may choose the deliverable security to be allocated to the maturity ladder. An Islamic Bank must, however, take account of any conversion factor specified by the exchange where the instrument must be delivered.

8.53. Swaps

(1) An Islamic Bank must treat a swap as 2 notional positions in government securities with maturities. Both legs of the swap must be reported at their market values.

(2) For swaps that pay or receive a fixed or floating profit rate against some other reference price (for example, a stock index), an Islamic Bank must:

a) enter the profit rate component into the appropriate maturity category; and
(b) include any equity component in the measurement of equity risk.

(3) Each leg of a cross-currency swap must be reported in the maturity ladder for the currency concerned. The Capital charge for any foreign exchange risk arising from the swaps must be calculated in accordance with Rules 8.14 to 8.17.

8.54. Shari’ah-compliant hedging instruments

(1) In the measurement of profit rate risk in the trading book, an Islamic Bank must include profit rate Shari’ah-compliant hedging instruments and off-balance-sheet instruments in the trading book if those instruments react to changes in profit rates.

(2) An Islamic Bank must convert Shari’ah-compliant hedging instruments into positions in the relevant underlying to enable an Islamic Bank to calculate specific and general risk Capital charges. To determine the Capital charges, the value of the positions must be the market value of the underlying or notional underlying.

(3) Positions in Shari’ah-compliant hedging instruments are subject to charges for general risk in the same way as cash positions. However, matched positions are exempt from the charges if the positions satisfy the criteria in rule 8.55 or 8.56.

(4) Positions in Shari’ah-compliant hedging instruments must be allocated to a maturity ladder and treated in accordance with this rule and the maturity method.

8.55. Criteria for matching Shari’ah-compliant hedging instrument positions

(1) An Islamic Bank may offset a matched position in Shari’ah-compliant hedging instruments if the positions relate to the same underlying instruments, have the same nominal value and are denominated in the same currency.

(2) For swaps and binding unilateral promises:

(a) the reference rate (for floating-rate positions) must be identical and the profit rate must differ by no more than 15 basis points; and
(b) the next profit-fixing date (or, for fixed-profit-rate positions or binding unilateral promises, the residual maturity) must comply with the following requirements:

(i) if either instrument has a profit-fixing date or residual maturity up to and including 1 month in the future, the dates or residual maturities must be the same for both instruments;

(ii) if either instrument has a profit-fixing date or residual maturity more than 1 month, but no more than 1 year, in the future, the dates or residual maturities must be within 7 days of each other;
(iii) if either instrument has a profit-fixing date or residual maturity more than 1 year in the future, the dates or residual maturities must be within 30 days of each other.

(3) An Islamic Bank that writes options may offset the delta-equivalent values of options (including the delta-equivalent value of legs arising out of the treatment of caps and floors in accordance with delta-plus method in Rule 8.24).

(4) However, for offsetting between a matched position in a binding unilateral promise and its underlying, Rule 8.56 applies.

8.56. Criteria for offsetting Shari’ah-compliant hedging instrument positions

(1) An Islamic Bank may offset long and short positions (whether actual or notional) in identical instruments with exactly the same issuer, profit rate, currency and maturity.

(2) An Islamic Bank may offset a matched position in a binding unilateral promise and its corresponding underlying. The net position must be reported.

(3) An Islamic Bank may offset positions in a binding unilateral promise with a range of deliverable instruments and the corresponding underlying only if:

(a) there is a readily identifiable underlying security; and
(b) the price of that security and the price of the binding unilateral promise move in close alignment.

(4) An Islamic Bank must treat each leg of a cross-currency swap or binding unilateral promise in foreign exchange transaction as a notional position in the relevant instrument, and must include the position in the calculation for each currency.

8.57. Market risk Capital charges for Islamic financial contracts

This section describes and sets out the market risk Capital charges applicable to the main types of Islamic Financial Contracts typically employed by Islamic Banks across the world.

8.58. Treatment of murabahah and related contracts

(1) An Islamic Bank is exposed to market risk under a murabahah contract when the asset is available for sale and on firm’s balance sheet.

(2) The Capital charge for a murabahah contract is 15% on the position. There is no Capital charge for a binding MPO contract or a CMT.

Guidance

In the case of a CMT where an Islamic Bank holds on to the commodity for a longer period than normal (for example, following the customer’s refusal to honour its commitment to buy) the commodity is subject to a Capital charge of 15%.

8.59. Treatment of bai bithaman ajil

The Capital charge for a bai bithaman ajil contract is 15% on the position. There is no Capital charge for a commodity bai bithaman ajil.

8.60. Treatment of salam and related contracts

Under a salam contract, an Islamic Bank is exposed to market risk after an Islamic Bank has paid the purchase price to the seller and before the purchased commodity is sold and delivered to a buyer.

Table 10.7.4AMarket risk Capital charge for salam without parallel salam

Stage of contract	Capital charge
firm has paid purchase price to salam customer (seller)	15% on the long position of salam exposures
firm has received purchased commodity but has not sold and delivered the commodity to a buyer	15% on the long position of salam exposures

Table 10.7.4BMarket risk Capital charge for salam with parallel salam

Stage of contract

Capital charge

firm has paid purchase price to salam customer (seller)

15% on the net position (that is, after netting of salam exposures against parallel salam exposures)

plus

3% on the gross position (that is, the sum of the salam exposures and parallel salam exposures)

firm has received purchased commodity but has not sold and delivered the commodity to a buyer

Note: The parallel salam does not extinguish the requirement for capital from the first salam contract.

8.61. Treatment of istisna without parallel istisna

(1) If an Islamic Bank is the seller under an istisna without parallel istisna contract, an Islamic Bank is exposed to market risk when there is unbilled work-in-process inventory. The Capital charge for the contract is 1.6% of an Islamic Bank’s unbilled work-in-process inventory.

(2) If an Islamic Bank is the buyer under an istisna without parallel istisna contract, an Islamic Bank is exposed to market risk as it makes progress payments to the supplier. The Capital charge for the contract is 15% of the work-in-process inventory.

8.62. Treatment of istisna with parallel istisna

(1) There is no Capital charge for an istisna with parallel istisna contract if there is no provision in the parallel istisna contract that allows the seller to increase or vary the selling price. Also, there is no Capital charge if there is a written undertaking given to an Islamic Bank that the contractor’s performance (including work-in-process) is the responsibility of the ultimate customer.

(2) However, there is a Capital charge of 1.6% of an Islamic Bank’s unbilled work-in-process inventory if:

(a) there is a provision in the parallel istisna contract that allows the seller to increase or vary the selling price; or
(b) there is no written undertaking that the contractor’s performance is the responsibility of the ultimate customer.

8.63. Treatment of ijarah and related contracts

(1) For an operating ijarah, an Islamic Bank is exposed to market risk (from possible fluctuations in the price of the asset) and is subject to Capital charges as follows:

(a) 8% of the residual value of the asset during the lease;

(b) 15% of the carrying value of the asset after the expiry of the lease contract until the asset is re-leased or disposed of.

(2) There is no Capital charge for an IMB contract or any other ijarah contract.

8.64. Treatment of diminishing musharakah

(1) The Capital charge for a diminishing musharakah contract depends on the category of the enterprise or asset to which the contract relates.

(2) If the contract is in relation to a private commercial enterprise to undertake trading activities in foreign exchange, shares or commodities, the Capital charge depends on the underlying asset as set out in this chapter.

(3) If the contract is in relation to a joint ownership of real estate or movable assets through musharakah with murabahah subcontract, the Capital charge is 15% (that is, the charge for the murabahah subcontract, as set out in Rule 8.58).

(4) If the contract is in relation to a joint ownership of real estate or movable assets through musharakah with ijarah subcontract, the Capital charge is 8% or 15% (that is, the charge for the ijarah subcontract, as set out in Rule 8.63).

8.65. Treatment of mudarabah

(1) The Capital charge for a mudarabah contract depends on the category of the enterprise or asset to which the contract relates.

(3) If the contract is in relation to a placement in the interbank market, there is no Capital charge except if the funds are invested in foreign exchange. The Capital charge for a mudarabah contract where the funds are invested in foreign exchange is that calculated in accordance with Rule 8.14 (foreign exchange risk).

8.66. Treatment of qardh

There is no Capital charge for a qardh contract except if the loan is provided in a foreign currency or in the form of a commodity. For qardh-based financing in a foreign currency or commodity, the Capital charge is that calculated in accordance with Rule 8.14 (foreign exchange risk) or Rule 8.29 (commodities risk), as the case requires.

8.67. Treatment of wakalah

(1) If a wakalah contract is in relation to a private commercial enterprise to undertake trading activities in foreign exchange, shares or commodities, the Capital charge depends on the underlying asset as set out in this chapter.

(2) If the contract is in relation to a placement in the interbank market, there is no Capital charge except if the funds are invested in foreign exchange. The Capital charge for a wakalah contract where the funds are invested in foreign exchange is that calculated in accordance with Rule 8.14 (foreign exchange risk).