Central Bank of Jordan: Capital Adequacy Instructions under Basel III Standard No. 67/2016

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Central Bank of Jordan

Capital Adequacy Instructions Under the Basel III Standard No. (67/2016)

Table of Contents

Chapter One: Scope of Application 4 Chapter Two: Regulatory Capital Requirements 7 First: Components of Regulatory Capital 7 Second: Capital Elements 7 Third: Elements Qualifying for Capital Components 8 Fourth: Regulatory Adjustments (Deductions from Capital) 18 Fifth: Application of the Instructions 23 Chapter Three: Additional Capital Requirements 24 Chapter Four: Risk Coverage 26 First: Credit Risk (Standardized Approach) 26 Second: Credit Risk Mitigations 39 Third: Operational Risk 58 Fourth: Market Risk (Standardized Approach) 64 Chapter Five: Leverage Ratio 79

List of Appendices: Appendix (1): Investments in Banks, Securities Companies, and Other Financial Institutions Not Consolidated 80 Appendix (2): Illustrative Example for Calculating Minority Interests 81 Appendix (3): Corresponding Deduction Approach 85 Appendix (4): Illustrative Example for Deduction Limits 86 Appendix (5): Regulatory Capital 88 Appendix (6): Steps the Central Bank Will Follow Regarding Capital to Address Cyclical Fluctuations 90 Appendix (7): Alignment of External Credit Ratings 91 Appendix (8): Ministries and Institutions Eligible for Preferential Risk Weights for the Jordanian Government (0%) 92 Appendix (9): Establishments and Institutions Eligible for Preferential Risk Weights for Banks 94 Appendix (10): Establishments and Institutions Eligible for Preferential Risk Weights for Corporations 96 Appendix (11): Conditions Required for Small Enterprises to be Included in the Regulatory Retail Portfolio 97 Appendix (12): Eligible Residential Loans 98 Appendix (13): Specialized Lending 100 Appendix (14): Business Lines under the Standardized Approach 104 Appendix (15): Specific Risks for Debt Instruments Subject to Interest Rate Risk 105 Appendix (16): General Risks for Instruments Subject to Interest Rate Risk 106 Appendix (17): General Risks for Debt Instruments Subject to Interest Rate Risk 107 Appendix (18): Market Risk for Equity Instruments Held for Trading 109 Appendix (19): Market Risk for Foreign Exchange Rates and Gold 110 Appendix (20): Simplified Method for Calculating Commodity Risks 111 Appendix (21): Market Risk Arising from Derivative Contracts Held for Trading 112 Appendix (22): Counterparty Risk for Repurchase Agreements and Reverse Repos, and Securities Lending and Borrowing 113 Appendix (23): Counterparty Risk for Received/Delivered Shares Not Yet Settled 114 Appendix (24): Leverage Ratio 115

Chapter One: Scope of Application

First: These Instructions apply to all banks operating in the Kingdom on a unified basis, as well as at the levels indicated below, such that the Central Bank of Jordan is provided with capital adequacy forms for these levels as follows:

The Banking Group [1] Including affiliated financial companies and holding companies (excluding insurance companies). Jordan branches and foreign branches. Jordan branches. Foreign branches individually. Affiliated banking companies individually.

Second: Consolidation Mechanism for the Purpose of Applying the Capital Adequacy Standard

1. Banks and other financial companies consolidated within the Banking Group: 1.1. Financial company data shall not be consolidated if held as repayment of debt or held temporarily for sale, or if subject to special legislation that does not allow consolidation. 2.1. In the event of non-consolidation for capital adequacy calculation purposes and the financial statements of the company are consolidated for accounting purposes, the value of the Bank's investment in the non-consolidated company must be deducted from the regulatory capital of the Banking Group. Simultaneously, for the purpose of calculating capital adequacy, the assets, liabilities, and minority interests (related to the non-consolidated company) must be deducted from the financial statements of the Banking Group.

2. Investments in Banks, Securities Companies, and Other Financial Companies: 1.2. Banks, securities companies, and other financial companies owned or controlled by the Bank must be fully consolidated to the greatest extent possible. In all cases, the accounts of banks, securities companies, and other financial companies owned at more than 50% of their capital must be consolidated, except in cases where this cannot be achieved due to impracticality, such as when the share is temporary in nature or when non-consolidation is legally required by the host supervisory authority. In the event of non-consolidation, the Carrying Value of the Bank's share in the capital of these companies must be deducted from regulatory capital, as shown in Appendix (1). 2.2. When consolidating the accounts of banks, securities companies, and other financial companies owned by majority (50% or more) or controlled (according to the definition of control in accounting standards) by the Bank with its financial statements, and for the purpose of calculating capital, the recognition of the capital of these companies in the parent bank's capital is subject to the guidelines regarding the recognition of minority interests provided in Item (Third/4) of Chapter Two. 3.2. In the case of affiliated companies (which consolidate their accounts) that have a capital deficit determined by the supervisory authority overseeing them (the host), the licensed bank concerned must inform the Central Bank of Jordan directly of this deficit. The Central Bank of Jordan will, in turn, monitor the measures taken by that affiliated company to rectify its situation. If it fails to rectify within the period granted to the bank, this deficit will be deducted from the regulatory capital of the licensed bank (the parent bank).

3. Investments in the capital of banks, financial companies, and non-consolidated insurance companies within the Banking Group: 1.3. Investments [2] in the capital of banks, financial companies, and insurance companies that are less than (10%) of the capital of these companies are treated as indicated in Item (Fourth/10) of Chapter Two. 2.3. Investments in the capital of banks, financial companies, and insurance companies that exceed (10%) of the capital of these companies are treated as indicated in Item (Fourth/11) of Chapter Two. 3.3. When consolidating the accounts of insurance companies owned by majority and/or controlled by the Bank, the Central Bank of Jordan will only allow the recognition of the surplus from the capital of insurance companies (the amount exceeding the regulatory capital required from the insurance company) under certain conditions [3] within the regulatory capital of the licensed bank, as indicated in the minority interests item number (Third/4) of Chapter Two. Banks that have recognized the surplus in the capital of their affiliated insurance companies must disclose to the public the amount of this recognized surplus within their capital. It should be noted that if the Bank's ownership in the capital of an insurance company is (more than 50% and less than 100%), the recognized surplus must be proportional to the ownership percentage. However, the surplus in the capital of insurance companies in which the Bank holds minority interests that are not material to the Bank will not be recognized, as the Bank lacks the ability to transfer the surplus in the capital of those companies due to its lack of control. 4.3. In the case of affiliated insurance companies (which consolidate their accounts) that have a capital deficit determined by the supervisory authority overseeing them, the licensed bank concerned must inform the Central Bank of Jordan directly of this deficit. The Central Bank of Jordan will, in turn, monitor the measures taken by that affiliated company to rectify its situation. If it fails to rectify within the period granted to the bank, this deficit will be deducted from the regulatory capital of the licensed bank (the parent bank).

Chapter Two : Regulatory Capital Requirements

First: Components of Regulatory Capital

This item addresses the definition of the components of regulatory capital for banks. Eligible capital is used together with risk-weighted assets to calculate the Capital Adequacy Ratio (CAR) of banks. This part will also outline the criteria and characteristics of each component of eligible capital.

Second: Capital Elements

Eligible regulatory capital consists of the following elements: 1.1. Tier 1 Capital (Going Concern Capital), which consists of the following: 1.1.1. Common Equity Tier 1 (CET1). 2.1.1. Additional Tier 1 (AT1). 2.1. Tier 2 (T2), which is capital used in the event of non-continuity (Gone Concern), as indicated in Item (Third/3) of this Chapter [4] .

Each of the three types of capital (CET1, AT1, T2) has a specific set of criteria that the financial instrument must meet before being included in the relevant category, as detailed later.

All capital elements are after excluding regulatory adjustments (deductions) specified in Item (Fourth) of this Chapter, such that total regulatory capital is not less than (12%) of risk-weighted assets for credit, market, and operational risks at all times, with the components of the ratio being as follows: 1.3. Common Equity Tier 1 (CET1) must not be less than (6%) of risk-weighted assets for credit, market, and operational risks at all times. 2.3. Additional Tier 1 (AT1) must not exceed (1.5%) of risk-weighted assets for credit, market, and operational risks at all times. 3.3. Tier 2 (T2) must not exceed (2%) of risk-weighted assets for credit, market, and operational risks at all times. 4.3. The Conservation Buffer ratio is (2.5%) of risk-weighted assets and must be composed of (CET1).

For the purpose of classifying a bank within the "Well Capitalized" category, its capital adequacy ratio must not be less than (14%). If the bank is classified as a Domestic Systemically Important Bank (D-SIB), for the purpose of classifying it as "Well Capitalized," its capital adequacy ratio must not be less than (14% + capital required for locally important banks according to the category to which the bank belongs and according to the timeframe provided in the instructions in force for dealing with locally systemically important banks).

Regarding banks with foreign presence, if host supervisory authorities impose a higher capital adequacy ratio than (12%), the bank, when consolidating its financial data for capital adequacy purposes, must increase its risk-weighted assets for its foreign presence proportionally to reflect the capital adequacy ratio required for its foreign presence. For example, if a bank has a foreign subsidiary and the capital adequacy ratio required for this subsidiary is (16%) and the risk-weighted assets for this subsidiary amount to (1) billion dinars, then the capital required for this subsidiary according to the host supervisory authority's instructions is (160) million dinars, while the capital required according to the Central Bank's instructions is (120) million dinars. To reflect the increase in the capital adequacy ratio for this subsidiary, the risk-weighted assets for the subsidiary when consolidating financial data will equal (160 million × 1 billion) / 120 million = 1.333 billion dinars.

Third: Elements Qualifying for Capital Components

1. Common Equity Tier 1 (CET1) 1.1. Common Equity Tier 1 (CET1) consists of the sum of the items listed below [5] [after regulatory adjustments (deductions) used to calculate Common Equity Tier 1 (CET1) and listed in Item (Fourth) of this Chapter]: 1.1.1. Ordinary shares (Common Shares) issued by the bank that meet the necessary criteria to be considered ordinary shares for regulatory purposes. 2.1.1. Retained earnings (accumulated profits/losses). 3.1.1. Other accumulated comprehensive income items, which include the accumulated change in fair value in full, foreign currency translation differences, and cash flow hedge reserves for non-current assets at fair value [6] . 4.1.1. Declared reserves: Legal reserve, voluntary reserve, share premium (discount), treasury share premium. 5.1.1. Any other unrestricted reserves subject to prior approval from the Central Bank of Jordan. 6.1.1. Minority interests, which are ordinary shares issued by subsidiaries of the bank and consolidated with the bank's accounts and held by a third party, which meet the inclusion criteria for Common Equity Tier 1 (CET1) as detailed in Item (Third/4) of this Chapter. 2.1. Net carried-forward profits after tax and after deducting expected distributions enter (CET1), while period losses are deducted. 3.1. Qualification Criteria for Ordinary Shares Issued by the Bank: To include any financial instrument in Common Equity Tier 1 (CET1), it must meet all the following criteria: 1.3.1. It represents the lowest priority claim among capital instruments in the event of the bank's liquidation. 2.3.1. It has the right to claim remaining assets proportionally to its share in capital after all priority debts are paid in the event of liquidation (i.e., it has an undefined, non-variable, and non-capped claim). 3.3.1. The nominal value is permanent and cannot be paid except in the event of liquidation (regardless of the existence of a repurchase option or any means of reducing capital on a voluntary basis allowed by prevailing laws). 4.3.1. The bank must not create any expectation at issuance that it will repurchase, redeem, or cancel the instrument, and the contractual terms must not contain any feature that could be understood as such. 5.3.1. Distributions are paid from distributable items (including retained earnings) and the level of distribution is not linked in any way to the paid-in value at issuance, nor is it subject to a contractual cap. 6.3.1. There is no case where distribution is mandatory, and therefore non-payment is not considered a default event. 7.3.1. Distributions are paid only after all contractual and legal obligations are settled, as well as payments due on higher-priority capital instruments. 8.3.1. They bear first any losses that may occur. 9.3.1. The paid-in value is considered part of equity (i.e., not a liability) for the purpose of determining solvency on the balance sheet, and is classified as equity according to relevant accounting standards. 10.3.1. They must be issued directly and paid in full, and the bank must not have financed the purchase of the instrument directly or indirectly. 11.3.1. The paid-in value is not guaranteed or covered by a guarantee from the issuer or any related party [7] , nor subject to any arrangements that enhance its legal or economic priority. 12.3.1. They must be issued only with the approval of the bank's owners, whether this approval is granted directly by the owners themselves or by persons authorized on behalf of these owners. 13.3.1. They are clearly and separately disclosed in the bank's balance sheet.

2. Additional Tier 1 (AT1) Capital 1.2. Additional capital consists of the sum of the items listed below [after regulatory adjustments (deductions) used to calculate Additional Tier 1 (AT1) capital]: 1.1.2. Financial instruments issued by the bank that meet the inclusion elements in Additional Tier 1 (AT1) and are not included in Common Equity Tier 1 (CET1), such as the nominal value of non-cumulative perpetual preferred shares (dividends) and similar instruments. 2.1.2. Share premium (discount) resulting from the issuance of financial instruments included in Additional Tier 1 (AT1); 3.1.2. Minority interests, which are instruments issued by subsidiaries of the bank and consolidated with the bank's accounts and held by a third party, which meet the inclusion elements in Additional Tier 1 (AT1) and are not included in Common Equity Tier 1 (CET1). 2.2. To recognize financial instruments issued by the bank that meet the inclusion criteria for Additional Tier 1 (AT1), they must meet or exceed the following minimum criteria: 1.2.2. Issued and paid in full. 2.2.2. Subordinate to depositors, general creditors, and bank-supported loans. 3.2.2. Unsecured and not covered by a guarantee from the issuer or any related party, nor containing any arrangements that could enhance their economic or legal priority against other bank creditors. 4.2.2. Perpetual, meaning no maturity date and value cannot be modified. 5.2.2. Repayable upon the issuer's request only after a minimum of (5) years from the date of issuance. If there is a call option for the issuer, it must comply with the following: Obtain prior approval from the Central Bank of Jordan for implementation. Not create any expectation that it will exercise the call option. It should be noted that the bank may not exercise the call option unless: a. It replaces the redeemed instrument with capital of similar or better quality, and the replacement is done under conditions that maintain the bank's ability to maintain sustainable income [8] . b. The bank proves that its capital level after exercising the call option is higher than the limit set by the Central Bank [9] . 6.2.2. Any repayment of principal (through repurchase or redemption) must be with the prior approval of the Central Bank of Jordan, and the bank must not imply to the market or assume that the Central Bank of Jordan's approval is guaranteed. 7.2.2. Dividend distribution / Interest payment option: The bank has the right at all times to cancel dividend distribution/interest payment. Non-payment does not in any way constitute a default event at the bank. The bank has the right to use unpaid dividends/interest to settle obligations due to it. Cancellation of dividend distribution/interest payment does not impose any legal or regulatory restrictions on the bank. 8.2.2. Dividends/interest are distributed through distributable items. 9.2.2. Dividend distribution/interest payment for the instrument must not be linked to a change in the bank's credit rating (i.e., dividend distribution or interest payment is not reviewed in the event of a downgrade of the bank's or banking group's credit rating). 10.2.2. Instruments classified as liabilities for accounting purposes (such as long-term bonds and classified as AT1) must contain a loss absorption feature either by: Converting into ordinary shares after a period of time based on a loss indicator in (CET1), such that conversion occurs when losses reach (30%) of (CET1), or A write-off mechanism for part of the financial instrument, such that this part covers losses, and the write-off has the following effects: a. Reduction of the claim on the instrument in the event of liquidation. b. Reduction of the paid-in value if the call option is used. c. Partial or full reduction of the interest value or distributions on the instrument. 11.2.2. The bank or any related party controlled by the bank or having effective influence over it must not have purchased the instrument, and the bank must not have financed the purchase of the instrument (directly or indirectly). 12.2.2. The instrument must not contain any features requiring the issuer to compensate the shareholder if a new instrument is issued at a lower price within a certain timeframe. 13.2.2. If the instrument is not issued by an operating unit established by the bank or within the holding company in the banking group (for example, issued by a special purpose vehicle (SPV)), the returns must be immediately available without restrictions to any operating unit or the holding company in the banking group, in a manner that meets all inclusion criteria or exceeds them within Additional Tier 1 (AT1) capital. 3.2. Share premium (discount) resulting from the issuance of financial instruments included in Additional Tier 1 (AT1): Unqualified share premium (discount) for inclusion as part of Common Equity Tier 1 (CET1) is allowed to be included in Additional Tier 1 (AT1) if this premium (discount) resulted from instruments included in Additional Tier 1 (AT1).

3. Tier 2 Capital 1.3. Tier 2 capital consists of the sum of the items below, after regulatory adjustments (deductions) used in calculating Tier 2 capital: 1.1.3. Instruments issued by the bank that meet the inclusion conditions for Tier 2 and are not included in Tier 1 capital. 2.1.3. Share premium (discount) resulting from the issuance of instruments included in Tier 2 (T2). 3.1.3. Minority interests, which are financial instruments issued by subsidiaries that consolidate their data with the bank, owned by a third party, and meet the inclusion basis for Tier 2 and are not included in Tier 1. 4.1.3. General banking risk reserve: not exceeding (1.25%) of the total risk-weighted assets calculated under the Standardized Approach. It should be noted that any provisions or reserves deducted by the bank to cover losses that have occurred are not recognized. 2.3. Financial instruments issued by the bank that meet the inclusion criteria for Tier 2 (Tier 2): The objective of Tier 2 is to provide capital instruments to absorb losses on a Gone Concern basis. To be considered part of Tier 2, any instrument must meet the following minimum criteria: 1.2.3. Issued and paid in full. 2.2.3. The financial instrument must not have priority in the claim on the funds of depositors and other creditors of the bank. 3.2.3. The financial instrument must not be secured or covered by a guarantee from the issuer or any related party, nor subject to any arrangements that could enhance its priority level economically or legally compared to the rights of depositors or other creditors of the bank. 4.2.3. Maturity: Original maturity must not be less than five years; The recognized portion within capital during the remaining five years of the financial instrument's life is subject to amortization ratios as follows:

Remaining Maturity Period Weight One year or less 0% More than one year – two years 20% More than two years – three years 40% More than three years – four years 60% More than four years – five years 80% More than five years 100% The financial instrument must not be subject to modifications that increase its value or to any conditions encouraging early repayment. 5.2.3. Repayable upon the issuer's request only after a minimum of (5) years from the date of issuance. If there is a call or redemption option, the bank must: Obtain prior approval from the Central Bank of Jordan for implementation; and Not create any expectation that it will exercise the call option. It should be noted that the bank may not exercise the call option unless: a. It replaces the redeemed instrument with capital of similar or better quality, and the replacement is done under conditions that maintain the bank's ability to maintain sustainable income [10] . b. The bank proves that its capital level after exercising the call option is higher than the limit set by the Central Bank [11] . 6.2.3. The investor (holder of the financial instrument) must not have the right to accelerate future financial payments (interest or principal) except in the event of bankruptcy or liquidation. 7.2.3. Dividend distribution/interest payment must not be linked to a change in the bank's credit rating (i.e., dividend distribution or interest payment is not reviewed in the event of a downgrade of the bank's or banking group's credit rating). 8.2.3. The bank or any related party controlled by the bank or having effective influence over it must not have purchased the instrument, and the bank must not have financed the purchase of the instrument (directly or indirectly). 9.2.3. If the instrument is not issued by an operating unit established by the bank or within the holding company in the banking group (for example, issued by a special purpose vehicle (SPV)), the returns must be immediately available in a manner that meets all the basis for inclusion in Tier 2 of capital. 3.3. Share premium (discount) resulting from the issuance of financial instruments within Tier 2 (Tier 2): Unqualified share premium (discount) for inclusion in Tier 1 is allowed to be included in Tier 2 if the instrument that led to this surplus is eligible for inclusion in Tier 2.

4. Minority Interests and Any Capital Issued by Consolidated Affiliated Companies Owned by a Third Party: 1.4. Ordinary Shares Issued by Consolidated Affiliated Companies: Minority interests arising from the issuance of ordinary shares by a consolidated affiliated company can be recognized within Common Equity Tier 1 (CET1) only if the following conditions are met: 1.1.4. The instrument that led to the minority interests meets all classification criteria as ordinary shares for regulatory capital purposes (as if it were issued by the bank itself). 2.1.4. The affiliated company that issued the shares is a bank. 3.1.4. The value of minority interests recognized within consolidated Common Equity Tier 1 (CET1) that meet the above two conditions will be calculated as follows: Sum of minority interests meeting the above two conditions minus the surplus in Common Equity Tier 1 (CET1) of the affiliated company attributable to minority shareholders. The surplus in Common Equity Tier 1 (CET1) from the affiliated company's capital equals the Common Equity Tier 1 (CET1) of the affiliated company minus the lower of the following: a. The minimum capital required from the affiliated company in the form of Common Equity Tier 1 (CET1) plus the Conservation Buffer [8.5% of risk-weighted assets for the affiliated company]. b. The affiliated company's share of consolidated Common Equity Tier 1 (CET1) plus the Conservation Buffer [8.5% [12] of risk-weighted assets for consolidated data pertaining to the affiliated company]. The amount of surplus in Common Equity Tier 1 (CET1) attributable to minority interests is calculated by multiplying the surplus in Common Equity Tier 1 (CET1) by the ownership percentage of minority shareholders in Common Equity Tier 1 (CET1). Appendix (2) illustrates an example of the calculation method. 2.4. Tier 1 Capital Eligible Issued by Consolidated Affiliated Companies: 1.2.4. Tier 1 capital instruments issued to third-party investors by bank subsidiaries fully consolidated with the bank can be recognized in Tier 1 of capital only if the instrument, as if it were issued by the licensed bank, meets all inclusion criteria for Tier 1 of capital. The recognized amount in Tier 1 will be calculated as follows: Sum of Tier 1 for the issuing affiliated company to third parties minus the surplus amount in Tier 1 attributable to third-party investors. The surplus in Tier 1 for the affiliated company is calculated by subtracting the lower of the following from the Tier 1 value of the affiliated company: a. The minimum Tier 1 required from the affiliated company plus the Conservation Buffer (Conservation Buffer) [10% 13 of risk-weighted assets for the affiliated company]. b. The affiliated company's share of the minimum Tier 1 requirements for the consolidated bank plus the Conservation Buffer (Conservation Buffer) [10% of risk-weighted assets for consolidated data pertaining to the affiliated company]. The value 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. Appendix (2) illustrates an example of the calculation method. 3.4. Tier 1 and Tier 2 Capital Eligible Issued by Consolidated Affiliated Companies: 1.3.4. The sum of capital instruments (i.e., instruments included in Tier 1 and Tier 2) issued by bank subsidiaries fully consolidated with the bank to third-party investors can be recognized in total capital only if the instrument, as if it were issued by the licensed bank, meets all inclusion criteria for Tier 1 and Tier 2 of capital. The value of capital that will be recognized in the total consolidated capital will be calculated as follows: Sum of capital instruments issued by the affiliated company to third parties minus the value of the surplus in the affiliated company's total capital attributable to the third party. The surplus in the affiliated company's total capital is calculated by summing the affiliated company's capital minus the lower of the following: a. The minimum capital of the affiliated company (T1 + T2) plus the Conservation Buffer (Conservation Buffer) [12% [13] of risk-weighted assets for the affiliated company]. b. The affiliated company's share of