Nigeria’s Islamic Banking Regulation Moves Towards Global Convergence

IFN Monthly Article on Nigeria: September 2018 Issue

Nigeria’s Islamic Banking Regulation Moves Towards Global Convergence

Nigeria’s Islamic banking industry is set to embrace best practices on disclosure, capital adequacy and supervision through the planned adoption of recognized international standards. In September 2018, the Central Bank of Nigeria (CBN) released a series of draft guidelines for non-interest financial institutions (Islamic banks) guided by IFSB standards and Basel II/III.

The guidelines prescribe the components of Tier 1 and Tier 2 capital as well as the methods for calculating capital requirements to cover credit and market risks of Islamic banks. The guidelines stipulate that credit risk arising from Murabaha, Salam, Ijarah, Istisna and Wakalah contracts will be measured according to the standardized approach of Basel II. In addition, Musharaka and Mudharaba contracts which have additional capital impairment risks will be risk weighted depending on the structure, purpose and nature of the underlying assets. Furthermore, Islamic banks that fail to demonstrate sufficient capacity to manage market risk will be prevented from trading financial instruments such as sukuk, commodities and currencies. Under the draft guidelines, Islamic banks will be required to maintain a minimum regulatory Capital Adequacy Ratio of 10% for banks with a National license, and 15% for banks with an International license. This is at par with conventional banks in the country, who are currently guided by the provisions of Basel II/III. The CBN has nevertheless reserved the right to raise the minimum Capital Adequacy Ratio of any Islamic bank based on its assessment of the bank’s risk profile.

To address rate of return risk and the attendant displaced commercial risk in Islamic banks, the CBN has also prepared draft guidelines for profit smoothing on Mudarabah and Wakalah accounts. This includes the establishment of Profit Equalization Reserves (PER), where a portion of the investment pool’s profit is appropriated before distributions are made to either the Islamic bank or the account holders. Other provisions of the guidelines include the establishment of an Investment Risk Reserve (IRR) where appropriations are made only from the profit due to account holders. The PER and IRR are to be applied for profit smoothing subject to the approval of the Islamic bank’s shari’ah advisers.

The CBN has also laid out detailed disclosure requirements for Islamic banks which aim to ensure that market participants are properly informed of the risk exposures and policies of the banks. Notable disclosures required under the draft guidelines include contract-specific risks and shari’ah governance.

The CBN expects to receive comments on the draft guidelines from market participants over a four-week period; thereafter, the new rules will be finalized. The regulator’s efforts provide further evidence of the continuous evolution of Nigeria’s regulatory landscape in favor of Islamic finance, and points to the potential for expansion that lies ahead. It is reassuring that the CBN has expressly adopted IFSB standards which are widely recognized and should enhance the competitiveness of Nigerian Islamic banks.