Wednesday 23, May 2018 by Jessica Combes

GCC yet to adopt recovery and resolution regimes

 

Mohamed Damak, Senior Director and Global Head of Islamic Finance, S&P Global Ratings analyses the need for the region’s regulators to implement these strategies 

Banks and regulators in the GCC are usually proactive to adopt best practices and international regulations when they come into force. However, regulators are taking their time to implement recovery—that is strategies to restore creditworthiness prior to bailout by authorities, and resolution regimes—the actions taken following the decision a bank has become unviable. Mohamed Damak, Head of Global Islamic Finance at S&P Global Ratings, believes this implementation will eventually come. However, it will require a significant mentality shift in how GCC governments and investors approach the banking systems.

Internationally, the introduction of recovery and resolution regimes is progressing. Following the 2008 global financial crisis, G7 finance ministers agreed to undertake important measures to support systemically important financial institutions to prevent another financial collapse. Some initiatives included regulators enhancing their monitoring and supervision methodologies, revamping on-site examination processes, and, in many countries, expanding their toolkit to process orderly resolutions of systemically important banks.

Governments in the GCC are generally highly supportive of their banking systems and do not hesitate to intervene to rescue banks. This is, in part, due to their position as shareholders of the banks, but also given their interests in safeguarding the financial stability of their banking system. For example, the most recent intervention in the GCC was a $43 billion liquidity injection in the Qatari banking system to curb the significant outflows of external funding following Qatar’s boycott in mid-2017.

Traditionally, investors perceive government support as a stabilising factor for banks’ creditworthiness, given some of the GCC governments’ strong balance sheets. Given the shift in international regulation and standards, we think the implementation of recovery and resolution regimes in the GCC is more a matter of time. How much longer before this happens remains a question.

If a GCC country were to implement an effective recovery and resolution regime for its banking system, S&P Global Ratings would review that country’s propensity to support its banking system and reassess the resulting impact on a banks’ credit quality with two likely scenarios: 1. Requirements put in place to increase a bank’s capacity to absorb losses could partially or fully replace the support given by government to reflect additional protection offered by these instruments to creditors 2. Requirements put in place that increase a bank’s capacity to absorb losses while keeping the option of government support provision would likely results in us incorporating the higher of the two into our credit rating of that institution.

RESOLUTION AND RECOVERY FOR CONVENTIONAL AND ISLAMIC BANKS
For conventional banks, bail-in-able liabilities are relatively easy to identify and consist primarily of instruments that are contractually bound to absorb losses at a certain stage (whether at the point of non-viability or earlier). Most of the recent capital increase in the GCC took the form of loss-absorbing hybrid instruments instead of core equity injections. For Islamic banks, however, Shari’ah interference may complicate the implementation of recovery and resolution regimes. There is a common perception that recovery and resolution regimes is easy to implement in Islamic finance, as one of the key principles requires a fair profit and loss-sharing between participants of a transaction, meaning natural and automatic bail-in.

However, successfully adopting the resolution framework is far more complex for Islamic banks as they conduct some of their operations in a debt-like format. According to Shari’ah principles, transferring assets with debtlike characteristics from one entity to another is possible at par only. This complicates an effective management-led recovery plan, or resolution, under which selected assets and liabilities should be moved from the failed bank to a viable entity.

In our view, the effective introduction of recovery and resolution regimes for Islamic banks would depend on clarifying which instruments would absorb losses other than in the event of default. We think that loss-absorbing instruments could include the Musharakah/Mudharaba-based products, where there is limited liquidity or reputation risks for the bank. These instruments include restricted PSIAs (no commingling between the bank’s activity and that financed by these instruments), and on balance-sheet PSIAs, provided that clients understand that they take the risk of losing their capital; receive proper remuneration for that risk; and contribute to the general pool of the bank’s assets. The instruments that GCC banks used to bolster their capital over the last three years (i.e. Mudharaba Sukuk) are also potentially loss-absorbing.

However, the market’s appetite for these instruments once their loss-absorbing features are made clearer is untested. An important factor in the success of a recovery and resolution framework in the GCC, in our opinion, would be better protection of the senior creditors in case of resolution. Customers bear the institution’s credit risk in Murabahah, Ijarah, or any other Islamic finance transaction that creates a direct and senior link between the risks taken by the clients and the creditworthiness of the bank. For these activities, the bank could be subject to higher capital requirements or holding Total Loss Absorbing Capacity (TLAC) instruments that will be bailed in and safeguard senior creditors.

RESOLUTION AND RECOVERY COULD HELP STABILITY OF FINANCIAL INDUSTRY
We believe the introduction of recovery and resolution regimes in jurisdictions where Islamic finance is significant could provide regulators with an additional tool to help the financial industry’s stability. As seen in Europe and the US, once fully implemented, recovery and resolution regimes become credible alternative to bailouts and, in turn, help maintain financial stability. We are also seeing a similar model emerge in other jurisdictions, such as Hong Kong, where regulators introduced resolution as a new additional tool, even if government support for senior creditors will likely continue to remain. At this stage however, it seems unclear, which path GCC governments will take.

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