Back Custom print Link Text Only Rich Text Print

  • CA-6 CA-6 Operational Risk

    • CA-6.1 CA-6.1 Definition of Operational Risk

      • CA-6.1.1

        Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events which includes but is not limited to, legal risk and Sharia compliance risk. This definition excludes strategic and reputational risk.

        January 2015

      • CA-6.1.2

        Sharia compliance risk is an operational risk facing Islamic banks which can lead to non-recognition of income and resultant losses.

        January 2015

      • CA-6.1.3

        Operational risk in Islamic bank licensees can be broadly divided into three categories:

        (a) General risks: Such risks are consequential upon various kinds of banking operations conducted by Islamic bank licensees that are common to all financial intermediaries.38 Nevertheless, the asset-based nature of financing products in banks such as Murabahah, Salam, Istisna' and Ijara may give rise to additional forms of operational risk in contract drafting and execution that are specific to such products;
        (b) Shari'a non-compliance risk: This is the risk of non-compliance resulting from the failure of an Islamic bank licensee's Shari'a governance mechanism (systems and personnel) to ensure its compliance with Shari'a rules and principles as determined by its Shari'a board or other relevant body in the related jurisdiction. This risk can lead to non-recognition of an Islamic bank licensee's income and resultant losses. The risk can take two broad forms in banks: (i) risks relating to potential non-compliance with Shari'a rules and principles in the Islamic bank licensees' operations, including the risk of non-permissible income being recognised, when there is a failure in Shari'a compliance; and (ii) the risk associated with the Islamic bank licensee's fiduciary responsibilities as Mudarib towards fund providers under the Mudarabah form of contract, according to which, in the case of misconduct or negligence by the Mudarib, the funds provided by the fund providers become a liability of the Mudarib. Sukuk structures may also be exposed to Shari'a non-compliance risk which may adversely affect the marketability, and hence the value, of the Sukuk; and
        (c) Legal risks: Legal risk includes, but is not limited to, exposures to fines, penalties or punitive damages resulting from supervisory actions as well as private settlements. Such risk can arise from either: (i) the Islamic bank licensee's operations — that is, from legal risks common to all financial intermediaries; or (ii) problems of legal uncertainty in interpreting and enforcing contracts based on Shari'a rules and principles. Legal risks also include the risk that a Sukuk structure in which an Islamic bank licensee is originator, sponsor, manager or investor fails to perform as intended because of some legal deficiency. The current section is concerned, not with exposures to legal risk as a Sukuk investor, but with potential losses due to exposures to legal risk as originator, sponsor or manager.

        38 Though operational risk related to the banking operations of banks can be considered similar to that of conventional banks in many respects, the characteristics of such risk may be different in banks in certain cases — for example: (i) Shari'a-compliant products may involve processing steps distinct from those of their conventional counterparts; (ii) banks typically hold different types of assets on their balance sheets compared to conventional banks — for example, physical assets or real estate; and (iii) banks may encounter varied risk related to information technology products and systems due to the requirements of Shari'a compliance.

        January 2015

    • CA-6.2 CA-6.2 The Measurement Methodologies

      • CA-6.2.1

        The framework outlined below presents two methods for calculating operational risk capital charges in a continuum of increasing sophistication and risk sensitivity:

        (a) The Basic Indicator Approach; and
        (b) The Standardised Approach.
        January 2015

      • CA-6.2.2

        An Islamic bank licensee will not be allowed to choose to revert to basic indicator approach once it has been approved for standardised approach without CBB's approval. However, if the CBB determines that an Islamic bank licensee using the standardised approach no longer meets the qualifying criteria for the standardised approach, it may require the Islamic bank licensee to revert to the basic indicator approach for some or all of its operations, until it meets the conditions specified by the CBB for returning to the standardised approach.

        January 2015

      • Basic Indicator Approach

        • CA-6.2.3

          Islamic bank licensees using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero must be excluded from both the numerator and denominator when calculating the average. See Paragraph CA-6.2.6 for approaches to be used where negative gross income distorts an Islamic bank licensee's Pillar 1 capital charge. The charge may be expressed as follows:

          KBIA = [∑(GI1..nα)]/n

          where:
          KBIA = the capital charge under the Basic Indicator Approach
          GI = annual gross income, where positive, over the previous three years (audited financial years)
          n = number of the previous three years for which gross income is positive
          α = 15%, relating the industry wide level of required capital to the industry wide level of the indicator.

          January 2015

        • CA-6.2.4

          The extent of losses arising from non-compliance with Sharia rules and principles cannot be ascertained owing to the lack of data. Therefore, Islamic bank licensees are not required to set aside any additional amount over and above the 15% of average annual gross income over the preceding three years for operational risk.

          January 2015

        • CA-6.2.5

          Gross income is defined as:

          (a) Net income from financing activities which is gross of any provisions (e.g. for unpaid profit or non-performing facilities), operating expenses (including outsourcing service providers), depreciation of Ijarah assets and excludes realised profits/losses from the sale of securities (e.g. sukuk) in the banking book;
          (b) Net income from investment activities. This includes the Islamic bank licensee's share of profit from musharakah and mudarabah financing activities; and
          (c) Fee income (e.g. commission and agency fee)

          Less:

          (d) Share of above income attributable to investment account holders and other account holders; and
          (e) Extraordinary or exceptional income and income from Takaful activities.
          Amended: July 2015
          January 2015

        • CA-6.2.6

          In case of an Islamic bank licensee with negative gross income for the previous three years, a newly licensed bank with less than 3 years of operations, or a merger, acquisition or material restructuring, the CBB shall discuss with the concerned Islamic bank licensee an alternative method for calculating the operational risk capital charge. For example, a newly licensed bank may be required to use the projected gross income in its 3-year business plan. Another approach that the CBB may consider is to require such licensed banks to observe a higher CAR.

          January 2015

        • CA-6.2.7

          Banks applying both approaches are required to refer to the principles set in Section OM-8.2 of Operational Risk Management Module.

          January 2015

      • The Standardised Approach

        • CA-6.2.8

          In the Standardised Approach, banks' activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. The business lines are defined in detail in Appendix CA-14. The Islamic bank licensee must meet the requirements detailed in Section OM-8.3 to qualify for the use of standardised approach.

          January 2015

        • CA-6.2.9

          Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. It should be noted that in the Standardised Approach, gross income is measured for each business line, not the whole bank, i.e. in corporate finance, the indicator is the gross income generated in the corporate finance business line.

          January 2015

        • CA-6.2.10

          The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line cannot offset positive capital charges in other business lines. Where the aggregate capital charge across all business lines within a given year is negative, then the input to the numerator for that year will be zero. If negative gross income distorts an Islamic bank licensee's Pillar 1 capital charge, the CBB will follow the approaches outlined in Paragraph CA-6.2.5. The total capital charge may be expressed as:

          KTSA = {∑ years 1-3 max[(GI1-8 Xβ1-8, 0]}/3

          where:

          KTSA = the capital charge under the Standardised Approach
          GI 1-8 = annual gross income in a given year, as defined above in the Basic Indicator Approach, for each of the eight business lines
          β1-8 = a fixed percentage, relating the level of required capital to the level of the gross income for each of the eight business lines.
          The values of the betas are detailed below.

          Business Lines Beta Factors (%)
          Corporate Finance (β1) 18
          Trading and Sales (β2) 18
          Retail Banking (β3) 12
          Commercial Banking (β4) 15
          Payment and Settlement (β5) 18
          Agency Services (β6) 15
          Asset Management (β7) 12
          Retail Brokerage (β8) 12
          January 2015