An Introduction to Islamic Finance: Theory and Practice

Regulation of Islamic Financial Institutions 309

Determining Risk Weights: An Example

Risk weights are assigned depending on the nature of the asset and the kind of
collateral. For example, if an Islamic bank provides murabahah fi nancing to a
client, and there is no pledged collateral, a risk weight of 100 percent is applied
to the value of the asset. On the other hand, if the client pledges collateral
with a market value of X, then the asset value is reduced by 75 percent of X
before applying the risk weight of 100 percent to the asset. An asset valued at
$500,000 will have a risk weight of $500,000 if there is no collateral and of
$425,000 if collateral worth $100,000 is pledged, as follows:

$425,000 = ($500,000 – $100,000 × 75%) × 100%.

For a musharakah (equity) investment, when there is no third - party guar-
antee, the credit risk weight of 400 percent is assigned. However, this weight
is reduced considerably when there is a third - party bank guarantee and a
risk weight of only 20 percent (for AAA - rated bank guarantees) is assigned.^2
In the Supervisory Discretion formula (see Table 14.2), the formula is
modifi ed to make appropriate adjustments to accommodate the existence of

TABLE 14.1 IFSB CAR standard formula

Eligible Capital

(Total Risk-weighted Assets)

PLUS

(Operational Risk Capital

Requirement)

MINUS Total Risk-weighted Assets

Funded by PSIA

Notes:

• Risk weighting includes weights for market and credit risk.


• PSIA = Profi t Sharing Investment Accounts.


• PSIA balances include Profi t Equalization Reserves (PER) and Investment Risk Reserve (IRR).

TABLE 14.2 IFSB CAR Supervisory Discretion formula

Eligible Capital

(Total Risk-weighted Assets)

PLUS

(Operational Risk

Capital Requirement)

(1 − α) × Total Risk-weighted MINUS

Assets Funded by PSIA MINUS α ×

Risk-weighted Assets Funded by PER

and IRR

Notes:

• Risk weighting includes weights for market and credit risk.


• PSIA balances include PER and IRR.


• α refers to the proportion of assets funded by PSIAs which is to be determined by the
  supervisory authorities. The value of α would not normally be expected to exceed
  30 percent.