The Islamic Financial Services Board (IFSB) released new draft guidelines on capital adequacy for Islamic banks and the risk management of takaful (Islamic insurance) companies, the industry body said in a statement on Thursday.

The Kuala Lumpur-based IFSB sets global guidelines for Islamic finance, although national financial regulators have the final say on how they apply these.

The IFSB released its original guidelines on capital adequacy in December 2005, based on Basel II standards which regulators were then applying around the world. Since then, global regulators have agreed on stricter Basel III standards which will be phased in over the next several years.

Sukuk (Islamic bonds), issued against assets owned by an Islamic bank, may be used by that bank as additional capital to meet regulatory minimums, the draft guidelines state.

The minimum maturity of the sukuk should be five years, and it should not have step-up features, such as periodic increases in the rate of return, giving an incentive to the issuer to redeem it. These provisions align the IFSB with Basel III.

Any capital raised through sukuk issues cannot be counted as part of the capital buffers mandated by Basel III, since sukuk are not common equity.

Because Islamic finance is more closely linked to real assets than conventional finance, it is less prone to credit bubbles, and Islamic banks do not engage in highly speculative trading, the IFSB said.

But it also noted that Islamic finance was in some ways vulnerable to cyclical swings in economies - for example, many Islamic instruments are based on commodity prices. So it makes sense for Islamic banks to build up countercyclical capital buffers in good times, the IFSB concluded; these buffers are one of the major provisions of Basel III.

The draft guidelines state how capital requirements should apply to banks' Islamic windows, and assign risk weightings to Islamic transactions such as musharaka and mudaraba. They indicate how exposure to contracts such as profit rate swaps, the Islamic equivalent of interest rate swaps, should be calculated.

Takaful

The draft guidelines for takaful do not set numerical standards for the industry but describe risks faced by Islamic insurers, including the risk that their products become non-compliant with sharia principles.

They also describe best practices for takaful providers to manage risks, supervise their funds and disclose information.

The IFSB plans a five-month public consultation period for the draft standards, with public hearings scheduled for Nov. 19 in Dubai and Jan. 22 in Kuala Lumpur. – Reuters