Central Bank of Jordan: Regulatory Capital Instructions for IFSB Standard No. 15 (Revised)

1 Central Bank of Jordan Regulatory Capital Instructions For the Revised Standard No. 15 Issued by the Islamic Financial Services Board (IFSB) No. 72 / 2018

2 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 Eligible for Capital Components 9........................................................... Fourth: Regulatory Adjustments (Deductions from Capital) 20................................................ Fifth: Calculation of Capital Adequacy Ratio 26........................................................... Sixth: Application of Instructions 27.......................................................................... Chapter Three: Additional Capital Requirements 28......................................................... Chapter Four: Risk Coverage 30........................................................................ First: Credit Risks (Standardized Approach) 30........................................................... Second: Credit Risk Mitigations 44................................................................. Third: Operational Risks 57.............................................................................. Fourth: Market Risks (Standardized Approach) 64................................................ Chapter Five: Leverage Ratio 77............................................. Chapter Six: Islamic Financing Formulas 79..............................................................

3 List of Appendices Appendix (1): Investments in Banks, Securities Companies, and Other Financial Companies Not Consolidated 97.................................................................................................... Appendix (2): Illustrative Example for Calculating Minority Interests 98................................................ Appendix (3): Corresponding Deduction Approach 102 Appendix (4): Illustrative Example for Deduction Limits ....................................................... 103 Appendix (5): Regulatory Capital ................................................................... 105 Appendix (6): Steps the Central Bank Will Follow Regarding Capital to Address Cyclical Fluctuations 107 Appendix (7): Alignment of External Credit Ratings ..................................................... 108 Appendix (8)*: Ministries and Institutions Eligible for Preferential Risk Weights for the Jordanian Government (0%)......................................................................................... 109 Appendix (9): Establishments and Institutions Eligible for Preferential Risk Weights for Banks ........... 111 Appendix (10): Establishments and Institutions Eligible for Preferential Risk Weights for Companies ....... 113 Appendix (11): Conditions Required in Small Establishments for Inclusion in the Regulatory Retail Portfolio ... 114 Appendix (12): Eligible Residential Finances........................................................... 115 Appendix (13): Business Lines under the Standardized Method .............................................. 117 Appendix (14): Market Risks for Equity Instruments Held for Trading................................. 118 Appendix (15): Specific Risks for Sukuk Included in the Trading Book Subject to Interest Rate Risks .. 119 Appendix (16): General Risks for Sukuk Included in the Trading Book Subject to Interest Rate Risks .... 120 Appendix (17): General Risks for Sukuk Subject to Interest Rate Risks................................ 121 Appendix (18): Market Risks for Foreign Currency Exchange, Gold, and Silver ........................ 123 Appendix (19): Simplified Method for Calculating Commodity Risks ............................................. 124 Appendix (20): Leverage Ratio ......................................... 125

4 Chapter One: Scope of Application First: These Instructions apply to all licensed Islamic banks in the Kingdom on a consolidated basis and to the levels indicated below, provided that the bank is organized into a banking group:

1. The Banking Group In accordance with the financial statements of the parent and parent companies (referred to as Parent Companies).
2. Jordanian and Foreign Branches.
3. Jordanian Branches.
4. Foreign Branches up to the limit.
5. Subsidiary Companies up to the limit.

Second: Consolidation Mechanism for Capital Adequacy Standard Purposes

1. Banks and Other Financial Companies Consolidated within the Banking Group: a. Financial company data shall not be consolidated if they are held as a temporary measure to repay debt or for sale, or if they are subject to special legislation that does not allow consolidation. b. If consolidation is not performed for capital adequacy calculation purposes, and the company's financial statements are consolidated for accounting purposes, the bank's investment value in the unconsolidated company must be deducted from the banking group's regulatory capital. Simultaneously, for capital adequacy calculation purposes, the assets, liabilities, and minority interests (related to the unconsolidated company) must be deducted from the banking group's financial statements.

2. Investments in Banks, Securities Companies, and Other Financial Companies: a. Banks, securities companies, and other financial companies owned or controlled by banks must consolidate their accounts in full up to the maximum limit. In all cases, the accounts of banks, securities companies, and other financial companies owned by more than 50% of their capital must be consolidated, except in cases where this is not possible due to the absence of adequate data or where consolidation is not legally required by the supervisory authority. In the case of non-consolidation, the carrying value of the bank's investment in these companies must be deducted from the regulatory capital if funded by the bank's own funds, and the bank's share of the carrying value of these companies' capital must be deducted from the regulatory capital in case of mixed funding, as shown in Appendix No. (1). b. When consolidating the accounts of banks, securities companies, and other financial companies owned by the majority (>50%) or controlled (as per the definition of control in accounting standards) by banks from their financial statements, and for capital calculation purposes, the consideration of the subsidiaries' capital in the parent bank's capital is subject to (Third 5) of the chapters regarding guidelines on the recognition of minority interests, which are in the Second items. c. In the case of subsidiary companies (which consolidate accounts) that have a capital deficit determined by the supervisory authority, the supervised licensed banks must inform the Central Bank of Jordan directly of this deficit. The Central Bank of Jordan will monitor the measures taken by the subsidiary to rectify its situation. If the deficit is not rectified 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 Parent Companies Not Consolidated from the Banking Group: a. Investments funded by the bank's own funds and funded by joint investment accounts in the capital of banks, financial companies, and insurance companies that do not exceed 10% of the capital of these companies are as stated in items (Fourth 10) of Chapter Two. b. Investments funded by the bank's own funds and funded by joint investment accounts in the capital of banks, financial companies, and insurance companies that exceed 10% of the capital of these companies are as stated in items (Fourth 11) of Chapter Two.

c. In the case of consolidated insurance companies owned by the majority or controlled by the bank and funded by the bank's own funds, 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 requirement of the insurance company) as part of the regulatory capital of the licensed bank, as shown in item (Minority Interests No. 5) of Chapter Two. Banks that have recognized a surplus in the capital of subsidiary insurance companies must disclose to the public the amount of this recognized surplus as part of their capital. It is noted that if the bank's ownership in the capital of the insurance company is (more than 50% and up to 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 rights and which are not material to the bank will not be recognized, as the bank lacks the ability to convert the surplus in the capital of those companies due to its lack of control.

d. In the case of subsidiary insurance companies (which consolidate accounts) that have a capital deficit determined by the supervised supervisory authority, the supervised licensed banks must inform the Central Bank of Jordan directly of this deficit. The Central Bank of Jordan will monitor the measures taken by the subsidiary to rectify its situation. If the deficit is not rectified within the period granted to the bank, this deficit will be deducted from the regulatory capital of the licensed bank (the parent bank).

1 The banking group refers to Jordanian Islamic banks.

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2 Includes direct and indirect investments regardless of whether they are classified within the banking portfolio or the trading portfolio.

3 The amount deducted from investments in equity and other investments in regulatory capital is subject to adjustment to reflect the amount of surplus in the capital of these companies that exceeds regulatory requirements. That is, the deducted amount will be equal to the investment or the regulatory capital requirement, whichever is lower, as stated in item (Third 5) of Chapter Two: Minority Interests and capital issued by consolidated subsidiaries. The amount representing the surplus (the difference between the investment in these companies and their regulatory capital) will be given a preferential risk weight like any other investment.

6 Chapter Two: Regulatory Capital Requirements First: Components of Regulatory Capital This item defines the components of regulatory capital for Islamic banks. Eligible capital is used alongside risk-weighted assets to calculate the capital adequacy ratio (CAR) for Islamic banks. Eligible capital will be used as the numerator for the capital adequacy ratio, and risk-weighted assets will be the denominator. This section outlines the standards and characteristics for each component of eligible capital.

Second: Capital Elements

1. Eligible regulatory capital consists of the following elements: a. Tier 1 Capital (Tier 1) (Capital to ensure the bank's going concern), consisting of:

2. Common Equity Tier 1 (CET1).

3. Additional Tier 1 Capital (AT1). b. Tier 2 Capital (Tier 2) is capital used in the event of non-going concern (liquidation), consisting of financial instruments compliant with Islamic Sharia provisions and certain reserves, as shown in item (Third 3) of this chapter.

4. Each type of capital (2T1, AT1, CET) is a group defined by criteria that the financial instrument must meet before being classified in the relevant capital category and meeting the criteria for classifying financial instruments into the first or second tier of capital to determine the Jordanian licensed bank's compliance with standards, especially the ability to absorb losses.

Instructions are issued requiring these instruments to absorb losses in the event the bank faces serious financial problems.

3. All capital elements are net of regulatory adjustments (deductions) specified in item (Fourth) of this chapter, and the total regulatory capital must not be less than 12% of risk-weighted assets for credit, market, and operational risks at all times. The components of the ratio are as follows: a. Common Equity Tier 1 (CET1) must not be less than 6% of risk-weighted assets for credit, market, and operational risks at all times. b. Additional Tier 1 Capital (AT1) must not exceed 1.5% of risk-weighted assets for credit, market, and operational risks at all times. c. Tier 2 Capital must not exceed 2% of risk-weighted assets for credit, market, and operational risks at all times. d. The Conservation Buffer is 2.5% of risk-weighted assets and must be composed of CET1.

4. For a bank to be classified in the "Well Capitalized" category, the capital adequacy ratio must not be less than 14%. However, for banks classified as SIBs-D, to be classified in the "Well Capitalized" category, the capital adequacy ratio must not be less than (14% + the required capital of the bank based on the category it belongs to and the systemic importance scale provided in the instructions for dealing with locally systemically important banks).

5. Regarding banks with foreign presence, if the supervisory authorities of the host countries require a capital adequacy ratio higher than 14%, the bank must consolidate its financial statements for capital adequacy purposes as if the risk-weighted assets for foreign presence were consolidated with a ratio proportional to the required capital adequacy ratio of the foreign presence. For example, if the required capital adequacy ratio of the foreign subsidiary is 16% and the risk-weighted assets of this subsidiary amount to 1 billion dinars, then the capital required from this subsidiary according to the host supervisory authority's instructions amounts to 160 million dinars, while the capital required according to the Central Bank of Jordan's instructions is 140 million dinars. To calculate the capital adequacy ratio for this subsidiary, the risk-weighted assets of the subsidiary when consolidating the financial statements will be (160 million x 1 billion) / 140 million = 1.143 billion dinars.

7 Third: Elements Eligible for Capital Components

1. Common Equity Tier 1 (CET1) a. Common Equity Tier 1 (CET1) consists of the sum of the items listed below [after regulatory adjustments (deductions) used to calculate Common Equity Tier 1 (CET1) and listed in (Fourth) of this chapter]:
2. Ordinary Shares (Common Shares) issued by the bank and meeting the necessary criteria to be considered ordinary shares for regulatory purposes.
3. Retained Earnings (Losses).
4. Other Comprehensive Income items, which include the full fair value reserve, foreign currency translation differences, and the banks' share of these items in case of mixed funds.
5. Reserves: Statutory reserves, discretionary reserves, general provision (deduction), share issuance premium.
6. Any other reserves not specified and subject to prior approval by the Central Bank of Jordan.
7. Minority Interests: Ordinary shares issued by subsidiaries of banks and consolidated with the bank's accounts and held by third parties, which meet the criteria for inclusion in Common Equity Tier 1 (CET1) as stated in item (Third 5) of this chapter. b. Net deferred profits after tax, after deducting expected distributions, enter CET1, while period losses are deducted. c. Criteria for Valuation of Ordinary Shares Issued by the Bank: To include any financial instrument in Common Equity Tier 1 (CET1), it must meet all the following criteria:
8. It represents the lowest priority claim among capital instruments in the event of the bank's liquidation.
9. It has the right to claim remaining assets in proportion to its share in capital after all priority claims are settled in the event of liquidation. (i.e., it has an undefined, variable right, not fixed or capped).
10. It bears any losses that may occur first.
11. The nominal value is permanent and cannot be repaid except in the event of liquidation (regardless of the existence of a call option or any means of reducing capital on a voluntary basis allowed by prevailing laws).
12. The bank must not create any expectations 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.
13. Distributions are paid from distributable items (including retained earnings) and are not linked in any way to the paid-in value and are not subject to contractual caps.
14. There is no case where the distribution is mandatory, and therefore non-payment is not considered a default event.
15. Distributions are paid only after settling all contractual and legal obligations, as well as paying what is due on higher-priority capital instruments.
16. The paid-in value is considered part of equity (i.e., not liabilities) for the purpose of determining financial solvency in the balance sheet, and is classified as equity according to relevant accounting standards.
17. It must be issued directly and paid in full, and the bank or any related party may not have funded the purchase of the instrument directly or indirectly.
18. The paid-in value is not guaranteed or covered by a guarantee from the issuer or any related party, and there must be no contractual terms or arrangements that enhance the priority of eligible instruments in the right to claim in the event of liquidation or default legally or economically.

Related party may include the parent company, a sister company, a subsidiary, or any other shareholder, and the holding company is considered a related party regardless of whether it is part of the banking group.

12. It is issued only with the consent of the bank's shareholders, whether this consent is granted directly by the shareholders themselves or by persons authorized on behalf of the shareholders.

13. It is clearly and separately disclosed in the bank's balance sheet.

14. Additional Tier 1 Capital (AT1) a. Additional Tier 1 Capital consists of the sum of the items listed below [after regulatory adjustments (deductions) used to calculate Additional Tier 1 Capital (AT1)]:

15. Financial instruments issued by the bank that meet the inclusion criteria in Additional Tier 1 Capital (AT1) [as stated in item (2 b)] and are not included in Common Equity Tier 1 (CET1), such as participation certificates, where the bank (after approval from the Sharia Supervisory Board) may issue participation certificates on the total assets of the bank, and these certificates must have the ability to absorb losses to be included in Additional Tier 1 Capital;

16. Premium (Discount) resulting from the issuance of financial instruments from Additional Tier 1 Capital (AT1) and not included in Common Equity Tier 1 (CET1) [unrecognized premium (discount) is allowed to be included as part of Common Equity Tier 1 (CET1) in Additional Tier 1 Capital (AT1) if this premium (discount) resulted from instruments included in Additional Tier 1 Capital (AT1)];

17. Minority Interests and the instruments issued by subsidiary companies consolidated with the bank's accounts and held by a third party, which meet the inclusion criteria in Additional Tier 1 Capital (AT1) and are not included in Common Equity Tier 1 (CET1). b. To consider financial instruments issued by the bank that meet the inclusion criteria in Additional Tier 1 Capital (AT1), they must meet the following minimum criteria or exceed them:

18. Issued and paid in full.

19. Subordinated to current accounts, non-participating investment accounts, other creditors, and benevolent loans supporting the bank.

20. Unsecured and not covered by a guarantee from the issuer or any related party, and do not contain any arrangements that could enhance their priority economically or legally in the right to claim against other bank creditors.

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4. Permanent, i.e., no maturity date and their value cannot be modified, and they do not have characteristics of periodic increase in yield rates, and there is no incentive for the issuer to redeem them.
5. If the participation certificates issued by the bank contain a call option for the issuer, the call option can be exercised at the issuer's request only after 5 years as a minimum from the date of issuance, and after meeting the following requirements by the bank:

• Obtaining prior approval from the Central Bank of Jordan for implementation.
• Not creating any expectations that the call option will be exercised. It is noted that the bank may exercise the call option only if: a. It replaces the redeemed instrument with one of similar or better quality, and the replacement is done on terms that maintain the bank's ability to maintain sustainable income. b. The bank proves that its capital level after exercising the call option is higher than the limit determined by the Central Bank of Jordan.

6. Any repayment of the principal amount (through redemption or conversion) must be with the prior approval of the Central Bank of Jordan, and the bank must not signal to the market or assume that the Central Bank of Jordan's approval is guaranteed.
7. Dividend Distribution Option:

• The bank has the right at all times to cancel dividend distributions.
• Non-payment does not mean in any way that there is a default event in the bank.
• The bank has the right to use undistributed dividends to settle obligations that have become due.
• Canceling dividend distributions does not result in imposing any legal or regulatory restrictions on the bank.

8. Dividends are distributed through distributable items.

The new instrument can be synchronized with the old instrument's conversion, but it cannot happen after. If the conversion option is implemented, the bank's capital adequacy assessment is subject to verification by the Central Bank of Jordan.

9. Dividend distribution for the instrument must not be linked to a change in the bank's credit rating (i.e., dividend distribution is not reviewed in the event of a downgrade of the bank's or banking group's credit rating).

10. 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 a call option on the instrument (directly or indirectly).

11. The instrument must not contain any features requiring the issuer to compensate the investor if a new instrument is issued at a lower price within a certain time frame.

12. If the instrument is not issued by a separate operating unit of the bank or within the holding company of the banking group [for example, issued by a Special Purpose Vehicle (SPV)], then the returns must be available to any unit or the holding company of the banking group without restrictions, in a manner that meets all the criteria for inclusion or exceeds them within Additional Tier 1 Capital (AT1).

13. Tier 2 Capital a. Tier 2 Capital consists of the sum of the items below, after regulatory adjustments (deductions) used in calculating Tier 2 Capital, as follows:

14. Instruments issued by the bank that meet the inclusion criteria for Tier 2 and are not included in the first tier of capital, where Islamic banks may issue capital instruments in the form of Mudaraba certificates or Wakala certificates, such that the assets that were securitized upon issuance of these certificates (as stipulated in the contract) can be converted into shares within equity in the event of the bank's inability to pay (insolvency). However, the issuance contract must explicitly state the conversion conditions and specifically the conversion to avoid the event requiring conversion and the percentage of occurrence of any uncertainty. Before the conversion process, the assets that were securitized are not available to settle the bank's obligations to current account holders, non-participating investment account holders, and other creditors.

The concept of general commitment does not apply to Mudaraba certificates, which refers to the ability to absorb losses. The reason is that the capital provider in Mudaraba certificates is not responsible for the general obligations incurred by the Mudaraba bank (especially the amounts due to current account holders). Therefore, what is stated in Mudaraba certificates is nothing but a form of participation certificates.

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After the certificates are converted into shares, in the event of the bank's insolvency, the Tier 2 capital will enjoy a rank equal to the rank of Common Equity Tier 1 and Additional Tier 1 Capital. 2. General Banking Risk Reserve (Self) and the bank's share of the General Banking Risk Reserve (Mixed): not exceeding 1.25% of the total risk-weighted assets for credit calculated using the standardized method. It is noted that any provisions or reserves deducted by the bank to face potential losses that have occurred will not be recognized. 3. Premium (Discount) resulting from the issuance of instruments included in Tier 2. 4. Minority Interests and the financial instruments issued by subsidiary companies whose data is consolidated with the bank, owned by a third party, and meeting the inclusion criteria for Tier 2 and not included in the first tier. 5. The bank's share of the surplus of the investment risk mitigation fund. b. Financial instruments issued by the bank that meet the inclusion criteria for Tier 2 (Tier 2): The purpose of Tier 2 is to provide loss-absorbing capital instruments on a non-going concern basis (Concern Gone). To consider any instrument within Tier 2, it must meet the minimum criteria as follows:

1. Ability to absorb losses.
2. Issued and paid in full, such that the bank or any company with control or significant influence over it does not have the ability to purchase this instrument or fund its purchase directly or indirectly.
3. The financial instrument must not have priority in claiming against current account funds and non-participating investment accounts.
4. The amounts must not be...