Palestine Monetary Authority

PALESTINE MONETARY AUTHORITY

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Instructions No. (07) of 2016

on Implementing Capital Adequacy Requirements under Basel II Regulations

Based on the provisions of Banking Law Decree No. (9) of 2010, and in accordance with the powers delegated to us, and in the public interest, we have issued the following instructions:

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Article (1)

Definitions

The words and expressions used in these Instructions shall carry the meanings assigned to them below, unless the context indicates otherwise:

• Credit Risk: Potential losses affecting a bank's profits and capital resulting from a borrower's inability to meet obligations on due dates, due to borrower-specific factors and/or general political or economic conditions, commercially expressed as default risk.

• Market Risk: Current or future risks that may affect a bank's revenues and capital, arising from fluctuations in interest rates, exchange rates, securities prices, and commodity prices.

• Operational Risk: Risk of exposure to losses resulting from inadequate or failed internal processes, people, and systems, or from external events. This definition includes legal risk but excludes strategic and reputational risks and regulatory risk.

• ICAAP: Internal Capital Adequacy Assessment Process.

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Palestine Monetary Authority

PALESTINE MONETARY AUTHORITY

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Article (2)

Scope of Application

The provisions of these Instructions shall apply to all banks licensed by the Palestine Monetary Authority to conduct banking business in Palestine.

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Article (3)

Basel II Implementation Guide

The attached guide, including all its chapters, appendices, and the new financial data report form (Call Report), constitutes an integral part of these Instructions. All banks are required to comply with the application of all chapters listed below for testing capital adequacy risk requirements and the Internal Capital Adequacy Assessment Process:

• Chapter One: Standardized Approach for Credit Risk.
• Chapter Two: Credit Risk Mitigation.
• Chapter Three: Market Risk.
• Chapter Four: Operational Risk.
• Chapter Five: Risk Management.
• Chapter Six: Application of the Supervisory Review Process under Pillar Two.
• Chapter Seven: Internal Capital Adequacy Assessment Process (ICAAP).

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Palestine Monetary Authority

PALESTINE MONETARY AUTHORITY

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Article (4)

Repeal

Instructions No. (2008/6) on Risk Management, and anything conflicting with the provisions of these Instructions, are hereby repealed.

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Article (5)

Implementation and Enforcement

1. All relevant authorities shall implement the provisions of these Instructions within their respective jurisdictions, and anything conflicting with them is repealed. These Instructions shall apply from the date of their issuance.

2. Banks shall be granted a period of up to one year from the date of issuance of these Instructions to submit their first Internal Capital Adequacy Assessment Process (ICAAP) report to the Palestine Monetary Authority in accordance with the requirements of Chapter Seven of the attached Basel II Implementation Guide.

Issued in Ramallah on Thursday, dated 25/08/2016.

Corresponding Hijri Date: 22 Dhu al-Qi'dah 1437

Assistant Governor for Financial Stability

Supervision and Inspection Department

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Basel II Instructions Implementation Guide

Chapter One: Standardized Approach for Credit Risk

1. General Introduction

The Basel Committee on Banking Supervision issued a report in June 2004 titled "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" commonly known as Basel II Regulations, which was issued in its final form in June 2006. According to this report, the Capital Adequacy Ratio (CAR) for banks is calculated as follows:

Capital Adequacy Ratio (CAR) = Regulatory Capital (Capital Base) / Risk-Weighted Assets (Credit Risk + Market Risk + Operational Risk)

• Tier 1 Capital Ratio: Tier 1 Capital / Risk-Weighted Assets ≤ 4%. This ratio must not be less than 8%.
• Regulatory Capital Ratio: (Tier 1 + Tier 2) / Risk-Weighted Assets ≤ 8%. This ratio must not be less than 12%.

The minimum capital adequacy requirements shall apply at both the solo and consolidated levels, where applicable.

2. General Conditions for the Standardized Approach for Credit Risk

2.1 Risk-weighted exposures shall be calculated using the Standardized Approach (SA), and the Palestine Monetary Authority reserves the option to incorporate the Internal Ratings-Based approach at a later stage. The Simple Approach for Credit Risk Mitigation (CRM) should also be used.

2.2 Banks are required to permanently comply with the necessary capital buffers to cover credit risk, ensuring that they maintain at all times a capital base to cover risks (credit, market, and operational) equivalent to at least 12% of their risk-weighted exposure value.

2.3 The Standardized Approach shall be applied to all bank assets in the banking book, with assets directly allocated to the capital base and assets in the trading book excluded for the purpose of calculating capital to cover market risk.

2.4 The Standardized Approach includes the following:

2.4.1 Classification of exposures into different categories based on the nature of the counterparty, characteristics of the transaction, or method of execution, as specified in paragraphs (4.1) to (4.16) of this Chapter of these Instructions.

2.4.2 The determination of various risk weights for each portfolio based on credit assessments issued by a third party (External Credit Assessment Institution "ECAI") recognized by the Palestine Monetary Authority, as specified in paragraphs (3.1) to (3.4) of this Chapter of these Instructions.

3. Standard Rating Grades

3.1 General Principles

3.1.1 Exposures shall be calculated with credit weights by weighting exposures inside and outside the balance sheet according to broad categories of credit risk associated with them. Credit ratings issued by rating agencies recognized in this Chapter of these Instructions shall serve as the basis for determining risk weights for all types of exposures (excluding residential mortgages, cash, and commercial credit portfolios).

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3.1.2 A bank may nominate one or more recognized credit rating agencies for the purpose of determining risk-weighted asset weights for assets inside and outside the balance sheet.

3.2 Credit Rating

3.2.1 According to these Instructions, six Credit Quality Steps (CQS) have been defined, and all credit ratings must be distributed across the rating scale shown below.

3.2.2 Credit ratings issued by the following rating agencies may be used to determine the rating grades used for weighting exposures to credit risk:

Weighting Exposures to Credit Risk:

Credit Quality Step (CQS)	Fitch Rating	Moody's Rating	S&P Rating
1	AA- to AAA	Aa3 to Aaa	AA- to AAA
2	A- to A+	A3 to A1	A- to A+
3	BBB- to BBB+	Baa3 to Baa1	BBB- to BBB+
4	BB- to BB+	Ba3 to Ba1	BB- to BB+
5	B- to B+	B3 to B1	B- to B+
6	Below CCC+	Below Caa1	Below CCC+

3.2.3 An exposure shall be assigned the "Unrated" rating grade if none of the credit assessments provided by any of the aforementioned rating agencies are applied to it.

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3.2.4 Credit ratings issued by Export Credit Agencies may be used if this Export Credit Agency is a member of the Organisation for Economic Co-operation and Development (OECD) arrangements regarding officially supported export credit guidelines, subject to the approval of the Palestine Monetary Authority.

3.2.5 The addition of other rating agencies to the list is subject to the discretion and approval of the Monetary Authority according to specific acceptance criteria.

3.3 Rating Quality

3.3.1 Long-term credit assessments shall be used, while short-term assessments for short-term exposures may only be used under exceptional circumstances.

3.3.2 Obtaining credit assessments for a fee paid by either the issuing entity or the rated counterparty is mandatory. Unsolicited credit assessments may only be used under exceptional circumstances and with the approval of the Palestine Monetary Authority.

3.3.3 When a rating agency provides a credit assessment for a specific exposure related to a particular issue, the rating grade for that exposure shall be determined according to the credit assessment given for that issue.

3.3.4 The rating grade for an exposure to an un-assessed issuing entity shall be determined according to the assessment given for another exposure on the same entity if the un-assessed exposure falls in a rank that satisfies the pari passu condition or ranks senior to that other exposure in all respects.

3.3.5 If a specific exposure is subject to credit assessments for different rating grades and different risk weights, the credit assessment with the highest weighted (i.e., least favorable) rating grade and risk weight must be used.

3.3.6 If a specific exposure is subject to three or more assessments based on different rating grades and more than one risk weight, the credit assessment with the highest weighted (least favorable) weight of the two least favorable credit grades must be used.

3.3.7 A credit assessment for an item linked to the local currency of the obligor cannot be used to derive the risk weight for another exposure linked to a foreign currency on the same obligor.

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3.4 Recognition of External Credit Assessment Institutions (ECAIs)

3.4.1 Banks are not permitted to use credit ratings other than those issued by a recognized External Credit Assessment Institution (ECAI). The Palestine Monetary Authority may recognize any ECAI upon approval of the request submitted by the concerned bank.

3.4.2 The primary purpose of establishing recognition criteria is to ensure that ECAIs meet the required levels of quality, consistency, and persistence necessary for institutions related to regulatory capital purposes within the Standardized Approach.

3.4.3 During the recognition process of an ECAI, the Palestine Monetary Authority verifies the following:

A. That the methodology for determining credit ratings is rigorous, systematic, continuous, and verified based on historical experience.

B. That the methodology used is free from external influences, constraints, or economic pressures that could affect the credit assessment/rating.

C. That the external rating institution possesses independence regarding ownership, organizational structure, financial resources, employment, expertise, and provides corporate governance for the external rating institution.

D. That credit ratings are subject to continuous review and respond to changes in financial conditions, with such reviews conducted following major events and at least once annually.

E. That credit ratings are publicly available, allowing all potential users to judge the reasonableness of their requirements.

F. That individual credit ratings in the market are viewed as credible and reliable by their users.

G. That a linkage is established between the Credit Quality Steps (CQS) used within the Standardized Approach framework and the credit ratings issued by the recognized External Credit Assessment Institution (ECAI).

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