Instructions No. 8 of 2018 Regarding the Implementation of Regulatory Capital Requirements in Accordance with Basel III Decisions

Annex No. (1) Guide to Regulatory Capital Requirements in Accordance with Basel III Decisions

Overview:

First: Introduction

1.1 Regulatory capital requirements seek to ensure that a bank's risk exposures are supported by a high-quality capital level capable of absorbing losses on a going-concern basis. This ensures the bank's continued ability to meet its obligations when due and to maintain the confidence of depositors, creditors, and other relevant parties.

Regulatory capital requirements also seek to protect depositors and creditors with lower priority in distribution in cases where the bank is unable to continue as a going concern, by holding assets that can be used to meet claims during liquidation.

1.2 The capital adequacy framework establishes a methodology for calculating capital adequacy ratios and their levels that every bank must apply. It is noted that this framework is based on internationally accepted standards, specifically the capital adequacy standards issued by the Basel Committee on Banking Supervision.

1.3 This guide sets out the general requirements regarding regulatory capital adequacy and eligible capital. This guide should be read in parallel with Instruction No. (07) of 2016 regarding the implementation of capital adequacy requirements in accordance with Basel II decisions, which specifies the requirements for calculating risk-weighted assets.

2. General Requirements:

2.1 This guide applies to all banks operating in Palestine and their branches abroad.

2.2 Every bank must apply the capital adequacy requirements contained in this guide to the bank's operations on an individual basis and on a consolidated basis, including all legal entities whose data are consolidated, whether they are financial or non-financial entities.

2.3 For the purpose of calculating the capital base on an individual basis, all investments of the bank in subsidiaries listed in the books are deducted.

2.4 Every bank must calculate the Common Equity Tier 1 (CET1) capital ratio and the Tier 1 capital ratio as follows:

a- Common Equity Tier 1 capital ratio = Common Equity Tier 1 Capital / Total Risk-Weighted Assets. b- Tier 1 capital ratio = Tier 1 Capital / Total Risk-Weighted Assets. c- Total Capital Adequacy Ratio = Total Regulatory Capital / Total Risk-Weighted Assets.

2.5 The following are the minimum thresholds that every bank must maintain at all times for capital adequacy:

Common Equity Tier 1 Ratio	Tier 1 Capital Ratio	Total Capital Adequacy Ratio	Total Capital Adequacy Ratio and Capital Buffer*
7%	8.5%	10.5%	13%

*Paragraph 2.7 below outlines the capital conservation buffer requirements.

2.6 The Monetary Authority has the discretion to determine higher capital adequacy ratios than the minimum levels, taking into account the specific characteristics of a bank's profile as indicated in these instructions, particularly the bank's risk profile.

2.7 Banks must hold additional capital buffers within the Common Equity Tier 1 capital category, in addition to the minimum thresholds for Common Equity Tier 1 and Tier 1 capital, as shown in the Total Capital Adequacy Level in Paragraph 2.5. Additional capital buffers include the following:

a- Capital Conservation Buffer (2.5% of Risk-Weighted Assets). b- Countercyclical Capital Buffer (determined by the weighted average of the prevailing countercyclical buffer rate in the country where the bank holds credit exposure). c- Specific capital buffers for banks classified as Systemically Important Banks at the local level (SIBs-D), composed of Common Equity Tier 1 (CET1), ranging from 1% to 3.5% of risk-weighted assets, with the Monetary Authority determining the required rate for each systemic bank individually.

2.8 Banks must continuously comply with the special capital requirements and Paragraph 2.7. Banks must inform the Monetary Authority immediately of any actual or expected decline below these levels and submit a comprehensive capital plan to the Monetary Authority in such cases, outlining the measures to be taken to address this decline.

2.9 The Monetary Authority will assess the capital plans submitted by the concerned bank, and based on this assessment, a decision will be made regarding the measures the bank must take and comply with. If the bank is unable to meet any of the minimum thresholds mentioned above, the Monetary Authority has the authority to impose restrictions on profit distribution at specific percentages.

Second: Eligible Regulatory Capital

3. Common Equity Tier 1 (CET1) Capital:

3.1 Common Equity Tier 1 capital consists of the following:

a- Issued and fully paid ordinary shares or their equivalent for supervisory purposes (see the explanations in Paragraph 6). b- Share Premium (resulting from the issuance of ordinary shares within this category). c- Statutory Reserve: The reserve deducted at a rate of 10% of the bank's annual net profit. d- Voluntary Reserve: The reserve deducted from the bank's annual net profit according to an internal decision by the bank's management. e- Retained Earnings (Losses): Net of declared distributions according to applicable accounting standards, and net of carried-forward losses. Carried-forward profits may be included if audited by the bank's external auditor. f- Other Reserves: Additional reserves formed in addition to the bank's annual net profit against unexpected future risks, whether by internal decision or according to the Monetary Authority (including the countercyclical buffer reserve). g- Accumulated balance of Other Comprehensive Income items, including carried-forward balances. h- Eligible Minority Interests that meet the necessary criteria for inclusion in the Common Equity Tier 1 category, as detailed in Paragraph 9 below. i- Deducted by the following supervisory adjustments (deductions) for calculating shareholders' equity listed below under item (j).

4. Additional Tier 1 (AT1) Capital:

4.1 Additional Tier 1 capital consists of the following:

a- Financial instruments issued by the bank that meet the inclusion criteria for Additional Tier 1 capital as specified in Paragraph (6) and are not included in shareholders' equity (CET1). b- Share Premium (Discount) resulting from the issuance of financial instruments within Additional Tier 1 capital as mentioned in item (a) above. c- Financial instruments issued by the bank's subsidiaries (whose accounts are consolidated with the bank) and owned by a third party (Minority Interests), which meet the inclusion criteria for Additional Tier 1 capital and are not included in shareholders' equity (CET1). d- Supervisory adjustments (deductions) used to calculate Additional Tier 1 Capital (AT1).

5. Tier 2 Capital:

5.1 Tier 2 capital consists of the following:

a- Instruments issued by the bank that meet the inclusion criteria for Tier 2 and are not included in the first tier of capital. b- Share Premium (Discount) resulting from the issuance of instruments included in Tier 2. c- Financial instruments issued by the bank's subsidiaries (whose accounts are consolidated with the bank) and owned by a third party (Minority Interests), which meet the inclusion criteria for Tier 2 and are not included in the first tier. d- Specific credit loss provisions - General Provisions (General Reserve for Operations): Calculated at 1.5% of net direct facilities (financing) provided by the bank and 0.5% of indirect facilities (financing) or Expected Credit Losses (Stage 1+2), whichever is greater (the amount disclosed must not exceed 1.25% of total risk-weighted assets). e- Supervisory adjustments applied in calculating Tier 2 capital.

Third: Inclusion Criteria in Regulatory Capital

6. Ordinary Shares:

6.1 The following conditions must be met for issued ordinary shares to be included in Common Equity Tier 1 (CET1) shareholders' equity:

a- Issued and fully paid. b- Represent the lowest priority claims in the distribution of funds in the event of the bank's liquidation. c- Absorb losses first upon occurrence, proportionally, and each ordinary share absorbs losses on a going-concern basis, proportionally, and at a constant rate with all other ordinary shares. d- The paid-up value is not guaranteed or covered by a guarantee from the bank or any related party (including the parent company, sister company, subsidiary, or any affiliated company), legally or economically, or subject to any arrangements that enhance its priority. e- Its original (nominal) value is permanent and cannot be repaid except in the event of liquidation. Regardless of the existence of buyback options or other means of reducing capital on a discretionary basis allowed by applicable laws. f- Shareholders have the right to claim assets remaining after the settlement of all priority claims in the event of liquidation (other claims are variable and not fixed or capped at a specific limit). g- Profit distributions are paid from distributable items (including retained earnings), and distribution levels are not linked to any other item such as paid-up capital at issuance, nor subject to a contractual cap, except for the limit where the bank is unable to distribute and at a level exceeding distributable items. h- Distributions are paid only after fulfilling all contractual and legal obligations, including paying what is due to higher-priority capital instruments. This means there are no preferential distributions. i- The paid-up value is considered part of capital (not a liability) for the purpose of determining insolvency. j- The paid-up value is classified as equity according to International Financial Reporting Standards. k- Disclosed clearly and separately in the bank's balance sheet. l- The bank does not undertake any action at issuance that would create an expectation that it will repurchase, redeem, or cancel the instrument, and the contractual terms do not contain any feature that implies this. m- The bank has not financed the purchase of the instrument directly or indirectly. n- Distributions are not mandatory under any circumstances, and therefore, non-payment of distributions is not considered a default event.

o- Ordinary shares are not purchased by the bank or any related party that exercises control over or significantly influences the bank. p- Issued with the approval of the shareholders of the issuing bank, whether granted directly by the owners themselves or by persons authorized on their behalf.

6.2 In the event that the bank issues different classes of ordinary shares with different voting rights (including those without voting rights), the classes of shares must be identical in all aspects except for the level of voting rights to be included in the Common Equity Tier 1 instruments.

7. Additional Tier 1 (AT1) Capital Instruments:

7.1 The following criteria must be met at a minimum for financial instruments issued by the bank to be recognized in Additional Tier 1 (AT1) capital:

a- Issued and fully paid. b- Have lower priority in distribution than depositors' rights, general creditors' rights, and loans supporting the bank. c- Unsecured and not covered by any guarantee from the issuer or any related party, or subject to any arrangements that could enhance their priority legally or economically against depositors, general creditors, and loans supporting the bank. d- Have no maturity date and their value cannot be modified, nor do they contain redemption incentives. e- May include a call option upon the request of the issuing bank only after five years from the date of issuance, subject to the following conditions:

• Obtaining prior approval from the Monetary Authority before exercising the call option.
• Not performing any act that would create an expectation that the bank will exercise the call option.
• The bank may not exercise the call option unless:
  1. It replaces the called instrument with capital of similar or higher quality, and the replacement is done under appropriate conditions that maintain the bank's financial capacity (simultaneous replacement of the old and new instruments is allowed, but not at a later date).
  2. The bank is able to demonstrate that it maintains capital levels above the threshold set by the Monetary Authority after exercising the call option.

7.2 Prior approval from the Monetary Authority must be obtained before carrying out the repayment process (either through buyback or redemption), and the bank may not assume the possibility of obtaining the Monetary Authority's approval or create expectations for market participants regarding this.

7.3 Profit distributions/interest payments must be made from distributable items and must meet the following conditions:

a- The bank has the right to make an appropriate decision regarding profit distributions/interest payments or cancel them at all times. b- The cancellation of distribution payments is not considered a default event. c- The bank has the right to use cancelled payments to settle due obligations. d- The cancellation of profit distributions/interest payments for Additional Tier 1 capital holders does not result in imposing any legal or regulatory restrictions on the bank, except regarding profit distributions for ordinary shareholders.

7.4 The instrument must not be credit-sensitive, meaning it is not linked wholly or partially to changes in the bank's credit rating.

7.5 Instruments classified as expenses for accounting purposes and included in (AT1) must contain a loss-absorption feature either through:

a- Conversion into ordinary shares after a time period according to a specified pre-determined objective trigger point. b- Write-off mechanism for part of the financial instrument, where this part covers losses, and the write-off has the following effects:

• Reduce the claim value on the instrument in the event of liquidation.
• Reduce the paid-up value if the buyout option is used.
• Partial or full reduction of the interest or distribution value on the instrument.

7.6 The instrument must not contain any restructuring clauses, such as clauses requiring the issuer to compensate shareholders if another instrument is issued at a lower price within a specific timeframe.

7.7 In the event that the instrument is not issued by an operating unit established by the bank or within the group's parent company (for example, issued by a Special Purpose Vehicle (SPV)), the returns on it must be immediately available without restriction or condition to any operating unit or the parent company and must be eligible for inclusion in Additional Tier 1 (AT1) capital.

7.8 Share Premium (Discount) resulting from the issuance of financial instruments included in Additional Tier 1 (AT1) capital, which are not eligible for inclusion as part of Common Equity Tier 1 (CET1) shareholders' equity, may be included.

8. Tier 2 Capital Instruments:

8.1 The following criteria must be met at a minimum for financial instruments issued to be recognized in Tier 2 capital:

a- Issued and fully paid. b- Considered to have lower priority than claims on depositors' funds and other general creditors of the bank. c- Unsecured and not covered by any guarantee from the issuer or any related party, or subject to any arrangements that could enhance their priority legally or economically against depositors and other general creditors. d- The original maturity date of the instrument must not be less than five years. The payable and calculable amount in regulatory capital must be amortized within five years from the maturity date in equal annual installments. The financial instrument must not be subject to modifications that may include clauses encouraging early repayment. e- May include a call option upon the request of the issuing bank only after five years from the date of issuance, subject to the following:

• Obtaining prior approval from the Monetary Authority before exercising the call option.
• Not performing any act that would create an expectation that the bank will exercise the call option.
• The bank may not exercise the call option unless:
  1. It replaces the called instrument with capital of similar or higher quality, and the replacement is done under appropriate conditions that maintain the bank's financial capacity (simultaneous replacement of the old and new instruments is allowed, but not at a later date).
  2. The bank is able to demonstrate that it maintains capital levels above the threshold set by the Monetary Authority after exercising the call option.
• The investor (holder of the financial instrument) does not have the right to accelerate future financial payments (interest or principal) except in the event of bankruptcy or liquidation.
• The instrument must not be credit-sensitive, meaning it is not linked wholly or partially to changes in the bank's credit rating.
• The bank or any other party controlled by the bank is not allowed to purchase these instruments, nor is the bank allowed to finance the purchase of these instruments directly or indirectly.
• In the event that the instrument is not issued by an operating unit established by the bank or within the group's parent company (for example, issued by a Special Purpose Vehicle (SPV)), the returns on it must be immediately available without restriction or condition to any operating unit or the parent company and must be eligible for inclusion in Tier 2 capital.
• Share Premium (Discount) resulting from the issuance of financial instruments included in Tier 2, which are not eligible for inclusion as part of the first tier, may be included.

9. Minority Interests and Capital Issued by Consolidated Subsidiaries and Owned by Third Parties.

9.1 Minority Interests arising from the issuance of ordinary shares by a consolidated subsidiary may be recognized in Common Equity Tier 1 (CET1) shareholders' equity only if the following conditions are met:

a- The instrument that led to the emergence of minority interests meets all classification criteria for ordinary shares for regulatory capital purposes (as if it were issued by the bank itself). b- The subsidiaries that issued the shares are banks. c- The value of minority interests recognized in Common Equity Tier 1 shareholders' equity of the consolidated entity meeting the above two conditions is calculated as follows:

1. The sum of minority interests meeting the above two conditions, minus the surplus in Common Equity Tier 1 of the subsidiary attributable to minority shareholders.
2. The surplus in Common Equity Tier 1 of the subsidiary is equal to the Common Equity Tier 1 of the subsidiary minus the lower of the following:
   • The minimum capital required from the subsidiary including Common Equity Tier 1 (CET1) plus the conservation buffer (9% of risk-weighted assets of the subsidiary).
   • The subsidiary's share of consolidated shareholders' equity plus the conservation buffer (9% of risk-weighted assets of the consolidated data pertaining to the subsidiary).
3. The amount of the surplus in Common Equity Tier 1 attributable to minority interests is calculated by multiplying the surplus in Common Equity Tier 1 by the ownership percentage of minority shareholders in Common Equity Tier 1.

9.2 Tier 1 capital instruments issued to third-party investors from subsidiaries consolidated with the bank in full may be recognized in the first tier of capital only if the instrument, as if it were issued by the bank, meets all inclusion criteria for the first tier of capital, and the recognized amount in the first tier is calculated as follows:

a- The sum of Tier 1 of the subsidiary issued to third parties, minus the surplus in Tier 1 attributable to third-party investors. b- The surplus in Tier 1 of the subsidiary is calculated by subtracting the lower of the following from the Tier 1 value of the subsidiary:

• The minimum Tier 1 required from the subsidiary plus the capital conservation buffer (10.5% of risk-weighted assets of the subsidiary).
• The subsidiary's share of the minimum Tier 1 requirements of the bank plus the capital conservation buffer (10.5% of risk-weighted assets of the consolidated data pertaining to the subsidiary). c- The amount of the surplus in Tier 1 attributable to third-party investors is calculated by multiplying the surplus in Tier 1 by the percentage of Tier 1 held by third-party investors.

9.3 The sum of capital instruments (either instruments included in the first tier and the second tier) issued by subsidiaries consolidated with the bank in full to third-party investors may be recognized in total capital only if the instrument, as if it were issued by the bank, meets all inclusion criteria for the first tier and the second tier of capital.

9.4 The capital value recognized in the total consolidated capital is calculated as follows:

a- The sum of capital instruments issued by the subsidiary to third parties, minus the value of the surplus in the total capital of the subsidiary attributable to the third party. b- The surplus in the total capital of the subsidiary is calculated as the total capital of the subsidiary minus the lower of the following:

• The minimum capital of the subsidiary (2T+1T) plus the capital conservation buffer (13% of risk-weighted assets of the subsidiary).
• The subsidiary's share of the minimum capital requirements of the bank (2T+1T) plus the capital conservation buffer (13% of risk-weighted assets of the consolidated data pertaining to the subsidiary). c- The amount of the surplus in total capital attributable to the third party is calculated by multiplying the surplus in total capital by the percentage of third-party ownership in total capital.

Note: Annex No. (1) shows a table of regulatory capital requirements. Annex No. (2) shows the treatment of investments in equity. Annex No. (3) shows an example of the treatment of minority interests.

Note: Supervisory Adjustments (Deductions from Capital)

10. Goodwill and Other Intangible Assets:

10.1 Goodwill and other intangible assets must be deducted from Common Equity Tier 1 (CET1) shareholders' equity, including goodwill included in the valuation of investments in banks, financial companies, and insurance companies that are outside the scope of consolidation for supervisory purposes.

10.2 International Financial Reporting Standards (IFRS) definitions are relied upon to define intangible assets for deduction purposes.

11. Deferred Tax Assets:

11.1 Deferred tax assets that depend on the future profitability of the bank for their realization must be deducted when calculating Common Equity Tier 1 (CET1) shareholders' equity. Netting between deferred tax assets and deferred tax liabilities is allowed if they relate to the same tax authority, and this does not conflict with the tax authority's instructions.

11.2 If an overpayment of income tax results in a claim or debt with the income tax authority, these amounts are classified accounting-wise as current assets, and their recovery does not depend on the future profitability of the bank; therefore, these amounts (debts) are subject to the home country risk weight.

12. Cash Flow Hedge Reserve:

12.1 The amount of the cash flow hedge reserve pertaining to hedges of items not measured at fair value in the balance sheet (including expected cash flows) is not recognized when calculating Common Equity Tier 1 (CET1) shareholders' equity, meaning the amounts credited are deducted and debited amounts are added.

12.2 The treatment in the preceding paragraph defines the elements of the cash flow hedge reserve that are not recognized for prudential purposes. If the element causing the fluctuation in shareholders' equity is eliminated, the reserve is placed on one side (the fair value of the derivative instrument and not the changes in the fair value of the hedged future cash flows).

13. Gains from Special Transactions (Securitization):

13.1 No increase in equity resulting from securitization transactions, such as those related to expected future income and resulting from gains from sales, is recognized when calculating Common Equity Tier 1 (CET1) shareholders' equity.

14. Accumulated Gains and Losses Resulting from Changes in the Bank's Own Credit Risk on Financial Liabilities Measured at Fair Value:

14.1 No unrealized gains or losses resulting from changes in the fair value of liabilities due to changes in the bank's own credit risk are recognized when calculating Common Equity Tier 1 (CET1) shareholders' equity.

15. Revaluation Gains (Losses) on Real Estate:

15.1 Unrealized gains from changes in fair value (revaluation) of land and buildings should be treated as follows:

a- Accumulated unrealized gains are deducted from Common Equity Tier 1 (CET1) capital. b- 45% of accumulated unrealized gains are included in the calculation of Tier 2 capital.

15.2 Full recognition of unrealized losses in the calculation of Common Equity Tier 1 (CET1) capital is required.

15.3 For the purpose of including 45% of accumulated unrealized gains as per item (15.1) above, land and property valuations must be conducted by an independent and approved valuer at least once a year or when there are indications of a likely significant decrease in value.

16. Investments in the Bank's Own Shares (Treasury Shares):

16.1 All of the bank's investments in its own shares, whether held directly or indirectly, must be deducted from Common Equity Tier 1 (CET1) shareholders' equity (unless they are not recognized according to applicable accounting standards). Additionally, any contractual obligation on the bank to purchase its own shares must be deducted when calculating Common Equity Tier 1 shareholders' equity. This treatment applies regardless of whether the exposure pertains to the banking book or the trading book. In addition to the following:

a- Long positions are deducted after deducting short positions for the same exposure, only if the short positions do not involve counterparty risk. b- Banks must take into account their investments in securities indices to deduct any exposures pertaining to the bank's own shares, and the total long positions in the bank's shares resulting from owning shares in securities indices may be offset against short positions in the bank's shares resulting from...