Instructions No. 9 of 2018 Regarding the Application of Capital Requirements for Islamic Banks

Annex No. (1)
Implementation Guide for Capital Adequacy of Islamic Banks

Chapter One: Regulatory Capital Requirements and Capital Buffer Sources

Preamble
These instructions are issued to align with the Capital Adequacy Framework for institutions limited to providing Islamic financial services, excluding insurance institutions, issued by the Islamic Financial Services Board (IFSB) and Standard No. (1) regarding Risk Management Guidelines. Some modifications have been made to better suit the specific environment of banks operating in Palestine.

The Capital Adequacy Ratio ("CAR") for banks is calculated as follows:

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

The minimum capital adequacy limits are required at both the individual and consolidated levels, where applicable.

1. Introduction
   1.1 Regulatory capital requirements aim to ensure that the Islamic 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 related parties. Regulatory capital requirements also aim to protect depositors and creditors with priority distribution rights in cases where the bank is unable to continue operations by preserving assets that may be used to meet claims during liquidation.

1.2 The capital adequacy framework establishes a methodology for calculating capital adequacy ratios and their levels, which each operating bank must follow. It is noted that this framework was developed based on internationally agreed standards, specifically the Capital Adequacy Framework issued by the Basel Committee on Banking Supervision, and the requirements of Standard No. (15) issued by the Islamic Financial Services Board.

2. General Requirements:
   2.1 This guide applies to Islamic banks operating in Palestine and their branches abroad.
   2.2 Every Islamic bank must apply the capital adequacy requirements contained in this guide to its operations on an individual and consolidated basis, including all legal entities whose data is consolidated, whether financial or non-financial.
   2.3 For the purpose of calculating the capital base on an individual basis, the bank's investments 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:
3. Total Capital Adequacy Ratio (1T + 2T)
   a. Common Equity Tier 1 Capital Ratio = Common Equity Capital / Total Weighted Risk Assets. b. Tier 1 Capital Ratio = Tier 1 Capital / Total Weighted Risk Assets.
   c. Total Capital Adequacy Ratio = Total Regulatory Capital / Total Weighted Risk Assets.

2.5 The following are the minimum limits 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 buffer requirements.

2.6 The Monetary Authority has the discretion to set capital adequacy ratios higher than the minimum levels stated in these instructions for a specific bank, taking into account the bank's specific characteristics and risk profile.

2.7 Banks must maintain additional capital sources within the Common Equity Tier 1 capital, in addition to the minimum limits for Common Equity Tier 1 and Tier 1 capital, as shown in Paragraph 2.5. These additional capital sources include:
a. Capital Conservation Buffer (Conservation Capital Buffer) at a rate of 2.5% of weighted risk assets. b. Countercyclical Capital Buffer (Countercyclical Capital Buffer), determined by the weighted average of the prevailing countercyclical buffer rates in the country where the bank holds credit exposures.
c. Capital buffers specific to banks classified as Systemically Important Banks (SIBs-D), formed from shareholders' equity (1 CET), ranging from 1% to 3.5% of weighted risk assets. The Monetary Authority determines the required percentage for each systemic bank individually.

2.8 Banks must continuously maintain the capital requirements specified in Paragraph 2.7. Banks must immediately notify the Monetary Authority of any actual or expected decline in these levels and submit a comprehensive capital plan to the Monetary Authority outlining the measures to be taken to address this decline.

2.9 The Monetary Authority evaluates the capital plans submitted by the concerned bank and, based on this, makes decisions regarding the procedures the bank must take and adhere to. If the bank is unable to meet any of the minimum limits stated above, the Monetary Authority has the right to impose restrictions on profit distribution at specified percentages.

Second: Regulatory Capital Components

3. Common Equity Tier 1 (CET1):
   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 explanations in Paragraph 6). b. Share Premium (Premium Share) resulting from the issuance of ordinary shares within this category.
   c. Statutory Reserve (Reserve Obligatory): A reserve deducted at 10% of the bank's annual net profit.
   d. Voluntary Reserve (Reserve Voluntary): A reserve deducted from the bank's annual net profit according to an internal decision by the bank's management. e. Retained Earnings (Earnings Retained): Net of announced distributions according to applicable accounting standards and cumulative losses. Cumulative losses may be included if reviewed by the bank's external auditor. f. Other Reserves (Reserve Other): Additional reserves formed from the bank's annual net profit as an additional requirement of the Monetary Authority (including countercyclical reserves). 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 10 below.
   i. Less: Regulatory adjustments (deductions) for calculating shareholders' equity included in item (k) below.

4. Additional Tier 1 Capital (1 AT):
   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 7 and are not included in shareholders' equity (1 CET). b. Issuance 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) that meet the inclusion criteria for Additional Tier 1 capital and are not included in shareholders' equity (1 CET).
   d. Regulatory adjustments (deductions) used to calculate Additional Tier 1 capital (1 AT).

5. Tier 2 Capital (2 Tier):
   5.1 Tier 2 capital consists of the following:
   a. Instruments issued by the bank that meet the inclusion criteria for Tier 2 capital and are not included in the first tier of capital. b. Issuance 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) that meet the inclusion criteria for Tier 2 capital and are not included in Tier 1.
   d. Specific credit loss provisions - General Provisions - (General Reserve for the bank's previous operations calculated at 1.5% of net direct facilities (financing) and 0.5% of non-direct facilities (financing) or Expected Credit Losses (1+2 Stage), whichever is greater. The amount disclosed here must not exceed 1.25% of total weighted risk assets). e. Regulatory 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 shareholders' equity (1 CET):
   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. Bear losses first upon occurrence proportionally, with each ordinary share absorbing 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), nor subject to any arrangements that enhance their legal or economic priority. e. Their original (nominal) value is permanent and cannot be repaid except in the case of liquidation. Regardless of the existence of a buyback option or other means of reducing capital on a voluntary basis allowed by applicable laws. f. Shareholders have the right to claim assets proportionate to their share in the capital after the settlement of all priority claims in the event of liquidation (no variable claims and no fixed or capped claims). g. Profit distributions are paid from distributable items (including retained earnings), and distribution levels are not linked to any other issued paid-up items and are not subject to a contractual cap, except for the limit where the bank is unable to distribute if the level exceeds distributable items. h. Distributions are paid only after fulfilling all contractual and legal obligations and 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 liquidation in the event of insolvency (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 perform any act at the time of 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 funded 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. The ordinary share is not purchased by the bank or any related party over which the bank exercises control or significant influence. p. Issued with the approval of the shareholders of the issuing bank, whether granted directly by the owners themselves or by authorized persons.

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

7. Additional Tier 1 Capital Instruments (1 AT):
   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 capital (1 AT):
   a. Loss Absorption Capacity: The Islamic bank, with the approval of the Sharia Supervisory Board, issues certificates based on Mudaraba (profit-sharing) with the characteristic of loss absorption. Holders of these certificates are considered partners with shareholders in equity according to the Mudaraba contract terms. Thus, partners share in the risks and returns of the bank's operations. b. Issued and fully paid.
   c. The bank or any other party controlled by the bank is not allowed to purchase these instruments, nor is the bank allowed to fund the purchase of these instruments directly or indirectly.
   d. They have lower priority in distribution than depositors' rights, general creditors, and subordinated loans to the bank. e. Not guaranteed and not covered by the issuer or any related party, nor do they contain any arrangements that could enhance their legal or economic priority over depositors, general creditors, and subordinated loans to the bank. f. No maturity date and their value cannot be modified, nor do they contain incentives for redemption. g. 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 is not allowed to exercise the call option unless:
     1. It replaces the instrument being called with capital of similar or higher quality, and the replacement must be under conditions that maintain the bank's financial capacity (simultaneous replacement of the old and new instruments is allowed, but replacement cannot occur on a later date).
     2. The bank is able to demonstrate that it maintains capital levels higher than the limit 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 is not allowed to assume the possibility of obtaining the Monetary Authority's approval or create expectations for market participants regarding this.

7.3 Distributions/returns must be paid from distributable items, and the following conditions must be met:
a. The bank has the right to make the appropriate decision regarding the distribution or cancellation of distributions at all times. b. The cancellation of distribution payments is not considered a default event.
c. The bank has the right to use cancelled installments to settle due obligations.
d. The cancellation of distributions for Additional Tier 1 capital holders does not impose any legal or regulatory restrictions on the bank except regarding distributions to Common Equity Tier 1 shareholders.

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

7.5 Instruments classified as equity for accounting purposes and included in (1 AT) must include a loss absorption feature either through:
a. Conversion into ordinary shares after a specified time period based on a pre-specified objective indicator (Pre-point Trigger), or, b. Write-off mechanism (off-Write) of a part of the financial instrument, where this part is to cover losses, and the write-off has the following effects:

• Reduction of the claim value on the instrument in the event of liquidation.
• Reduction of the paid-up value if the buyback option is used.
• Partial or full reduction of distributions on the instrument.

7.6 The instrument must not include any terms for recapitalization, such as terms requiring the issuer to compensate shareholders if another instrument is issued at a lower price within a specific timeframe.

7.7 If the instrument is not issued by an operating unit established by the bank or within the 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 capital (1 AT).

7.8 Issuance premium (discount) resulting from the issuance of financial instruments included in Additional Tier 1 capital (1 AT) which are not eligible for inclusion as part of Common Equity Tier 1 shareholders' equity (1 CET) 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. Loss Absorption Capacity: The Islamic bank, with the approval of the Sharia Supervisory Board, issues an instrument based on Mudaraba or Wakala (agency) convertible into equity rights upon the occurrence of certain events (Events Trigger). In the event of conversion, the supported capital equals the shareholders' rights with equal priority. The contract terms must specify the conversion conditions and the event that may lead to conversion to avoid ambiguity. b. Issued and fully paid.
   c. Considered lower priority than claims on depositors' funds and other general creditors of the bank.
   d. Not guaranteed and not covered by the issuer or any related party, nor do they contain arrangements that could enhance their legal or economic priority over depositors and other general creditors. e. The original maturity date of the instrument must not be less than five years. The outstanding and calculated amount in regulatory capital must be redeemed over five years from the maturity date through fixed installments. The financial instrument must not be subject to modifications that may include incentives for early repayment. f. 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 is not allowed to exercise the call option unless:
     1. It replaces the instrument being called with capital of similar or higher quality, and the replacement must be under conditions that maintain the bank's financial capacity (simultaneous replacement of the old and new instruments is allowed, but replacement cannot occur on a later date).
     2. The bank is able to demonstrate that it maintains capital levels higher than the limit 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 payments except in the event of bankruptcy or liquidation.
   • The instrument must not be credit-sensitive, meaning it is not linked in any way 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 fund the purchase of these instruments directly or indirectly.
   • If the instrument is not issued by an operating unit established by the bank or within the 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.
   • Issuance premium (discount) resulting from the issuance of financial instruments included in Tier 2 which are not eligible for inclusion as part of Tier 1 may be included.

9. Treatment of Investment Sensitivities Based on Profit and Loss Sharing Principle and Investment Rate Reserves

9.1 Investment accounts based on the profit and loss sharing principle are not considered part of the Islamic bank's capital because they do not meet the criteria described above for Common Equity Tier 1 (1 CET), Additional Tier 1 (1 AT), and Supporting Capital (2T). Therefore, investment risk reserves and the portion of the investment rate reserve belonging to investment account holders are not considered part of the Islamic bank's capital components and are treated as part of shareholders' equity. The investment risk reserve and the portion of the investment rate reserve belonging to investment account holders are deducted from total weighted risk assets.

10. Minority Interests and Capital Issued by Consolidated Subsidiaries and Owned by a Third Party:

10.1 Minority interests arising from the issuance of ordinary shares by a consolidated subsidiary may be recognized in Common Equity Tier 1 (1 CET) 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 issued by the bank itself). b. The subsidiaries that issued the shares are Islamic banks.
c. The value of minority interests recognized in Common Equity Tier 1 shareholders' equity meeting the above two conditions is calculated as follows:

• The sum of minority interests meeting the above two conditions, minus the surplus in Common Equity Tier 1 of the subsidiary belonging to minority interest holders.
• The surplus in Common Equity Tier 1 shareholders' equity of the subsidiary, minus the lesser of the following:
  1. The amount the bank earns from Mudaraba funds, before deducting the Mudarib's share, for the purpose of maintaining a specific level of investment return for investment account holders and increasing owners' equity.
  2. The amount the bank earns from investment account holders' profits, after deducting the Mudarib's share, for the purpose of protecting against future losses for investment account holders.
  3. The minimum capital required from the subsidiary for Common Equity Tier 1 (1 CET) plus the Conservation Buffer (9% of weighted risk assets for the subsidiary).
  4. The subsidiary's share of consolidated shareholders' equity plus the Conservation Buffer (9% of weighted risk assets for consolidated data pertaining to the subsidiary).
• The surplus amount in Common Equity Tier 1 belonging to minority interests is calculated by multiplying the surplus in Common Equity Tier 1 by the ownership percentage of minority interest holders in Common Equity Tier 1 shareholders' equity.

10.2 Tier 1 capital instruments issued to third-party investors from subsidiaries consolidated with the bank may be recognized in Tier 1 capital only if the instrument, as if issued by the bank, meets all inclusion criteria for Tier 1 capital. The recognized amount in Tier 1 is calculated as follows:
a. The sum of Tier 1 issued by the subsidiary to a third party, minus the surplus in Tier 1 belonging to third-party investors. b. The surplus in Tier 1 of the subsidiary is calculated by subtracting the lesser of the following from the Tier 1 value of the subsidiary:

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

10.3 The sum of capital instruments (either instruments included in Tier 1 and Tier 2) issued by subsidiaries consolidated with the bank to third-party investors may be recognized in total capital only if the instrument, as if issued by the bank, meets all inclusion criteria for Tier 1 and Tier 2 capital.

10.4 The capital amount recognized in total consolidated capital is calculated as follows:
a. The sum of capital instruments issued by the subsidiary to third parties, minus the surplus in the subsidiary's total capital belonging to the third party. b. The surplus in the subsidiary's total capital is calculated by subtracting the lesser of the following from the total capital of the subsidiary:

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

Note:

• Annex No. (1) shows the regulatory capital components model for the Islamic bank.
• Annex No. (2) shows the treatment of equity investments.
• Annex No. (3) shows an example of minority interest treatment.

Regulatory Adjustments (Deductions from Capital)

11. Goodwill and Other Intangible Assets:
    11.1 Goodwill and other intangible assets must be deducted from Common Equity Tier 1 (1 CET) shareholders' equity, including goodwill included in the valuation of investments in bank and financial capital and insurance companies that are outside the scope of consolidation for supervisory purposes.
    11.2 Definitions of international financial reporting standards (IFRS) are used to identify intangible assets for deduction purposes.

12. Deferred Tax Assets:
    12.1 Deferred tax assets that depend on the bank's future profits for realization must be deducted when calculating Common Equity Tier 1 (1 CET) shareholders' equity. Offsetting between deferred tax assets and deferred tax liabilities is allowed if they belong to the same tax authority, and this does not conflict with the tax authority's instructions.
    12.2 If a tax payment exceeds the due amount and results in a claim or debt against the income tax department, these amounts are classified as current assets and their recovery does not depend on the bank's future profits; therefore, these amounts (debts) are subject to the risk weight of the government.

13. Cash Flow Hedge Reserve (reserve hedge flow Cash):
    13.1 Recognition is not granted...