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Home > Capital Markets Best Practice > Capital Adequacy Requirements for Islamic Financial Institutions: Key Issues

Capital Markets Best Practice

Capital Adequacy Requirements for Islamic Financial Institutions: Key Issues

by M. Kabir Hassan and Ebid Smolo

Executive Summary

  • The global financial crisis revealed many flaws in the conventional financial system, and many identified the Islamic financial system as a viable alternative.

  • Both the Basel I and Basel II Accords were devised with an aim of improving the credibility and soundness of the financial system globally.

  • The differences between conventional and Islamic banks are apparent on both the liabilities and the assets sides. Although Basel II was never intended for the Islamic financial industry, it can be taken as the foundation and improved upon with respect to the nature and characteristics of Islamic banking.

  • Both the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) tried to develop capital adequacy ratio (CAR) guidelines for Islamic banks, taking into account Basel II recommendations as their basis.

  • While the AAOIFI’s recommendations are biased toward the liabilities side of the balance sheet, the IFSB’s recommendations consider the assets as well.

  • There is a dire need to differentiate between financial instruments in order to come up with an appropriate CAR for Islamic banks.

  • Proper measurement of CAR and the meeting of international standards will foster the credibility and soundness of the Islamic financial system worldwide. This will lead to the future growth of the industry.

Introduction

The Islamic financial industry (IFI) has grown tremendously in the last two to three decades. In short, Islamic finance refers to financial activities that are guided by the teachings of shariah (Islamic law), which strictly prohibits the payment and receipt of interest. Today, Islamic finance attracts both Muslim and non-Muslim market participants. The worldwide market for shariah-compliant Islamic financial products is estimated to be between US$800 billion and US$1 trillion. According to International Financial Services, London (IFSL), shariah-compliant assets had grown to US$951 billion by the end of 2008, which is a 25% increase from US$758 billion in 2007, and about 75% up from US$549 billion in 2006. The IFI is growing at 15–20% per annum—a rate that is much greater than the growth rate of the traditional (conventional) financial industry.

While the global financial crisis revealed serious weaknesses in the international financial system around the globe, the IFI showed signs of relative resilience to the shocks. It is even argued that if the principles of Islamic finance had been followed, the financial crisis would have been prevented. Nevertheless, some impact has been felt within the industry, revealing vulnerabilities that need to be addressed urgently in order to sustain the growth of the IFI.

Despite the fact that there is no consensus on the causes of the global financial crisis, various authors have highlighted several culprits. Some argue that the complexity and intensive use of structured financial products, derivatives, and other assets with uncertain fundamentals are to blame for the current financial crisis. Others say that easy monetary policy, financial supervision, and regulation, combined with excessive leveraging and credit growth, are fundamental factors that ignited the crisis.

All of the above brought the need for prudent regulation and supervision into the limelight. Lack of both supervision and regulation of the financial sector played an important role in the crisis. This led to the growth of unregulated exposures, which in turn led to excessive risk taking and weak liquidity risk management.

Being a niche industry, Islamic finance faces considerable challenges. For example, the lack of an efficient legal framework, standards and procedures, qualified manpower, effective government support, prudential regulations and supervision, internal controls, risk management, and external audits of Islamic banks are some of the challenges confronting the future growth of IFI.

Apart from the extraordinary growth and multiple challenges faced by the IFI, one daunting challenge is the compliance of Islamic banks with international standards and guidelines. Meeting international standards, such as the capital adequacy requirements set by the Basel II Accord, is not an easy task, as Islamic banks face different types of risks. For this reason, this article discusses the key issues in capital adequacy requirements for Islamic financial institutions.

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Further reading

Books:

  • Balthazar, Laurent. From Basel 1 to Basel 3: The Integration of State of the Art Risk Modeling in Banking Regulation. Basingstoke, UK: Palgrave Macmillan, 2006.
  • Schoon, N. “Basel II and capital adequacy.” In Habiba Anwar and Roderick Millar (eds). Islamic Finance: A Guide for International Business and Investment. London: GMB Publishing, 2008; pp. 169–175.

Articles:

  • Archer, Simon, Rifaat Ahmed Abdel Karim, and Vasudevan Sundararajan. “Supervisory, regulatory, and capital adequacy implications of profit-sharing investment accounts in Islamic finance.” Journal of Islamic Accounting and Business Research 1:1 (2010): 10–31. Online at: dx.doi.org/10.1108/17590811011033389
  • Hassan, M. Kabir, and M. A. Mannan Chowdhury. “Islamic banking regulations in light of Basel II.” American Journal of Islamic Social Sciences 27:1 (2010): 74–101.
  • Hassan, M. Kabir, and Mehmet F. Dicle. “Basel II and regulatory framework for Islamic banks.” Journal of Islamic Economics and Finance 1:1 (July–December 2005): 17–36.

Reports:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). “Statement on the purpose and calculation of the capital adequacy ratio for Islamic banks.” 1999.
  • Basel Committee on Banking Supervision. “International convergence of capital measurement and capital standards: A revised framework.” 1988.
  • Basel Committee on Banking Supervision. “Amendment to the capital accord to incorporate market risks.” 1996.
  • Chapra, M. Umer, and Tariqullah Khan. “Regulation and supervision of Islamic banks.” Occasional paper no. 3. Islamic Research and Training Institute, Islamic Development Bank, 2000.
  • Islamic Financial Services Board. “Capital adequacy standard for institutions (other than insurance institutions) offering only Islamic financial services.” Standard IFSB-2. December 2005. Online at: www.ifsb.org/standard/ifsb2.pdf
  • Islamic Financial Services Board. “Guidance note in connection with the capital adequacy standard: Recognition of ratings by external credit assessment institutions (ECAIs) on shari’ah-compliant financial instruments.” Guidance note GN-1. March 2008. Online at: www.ifsb.org/standard/eng_IFSB_Guidance_Note_CAS.pdf
  • Islamic Financial Services Board. “Guiding principles of risk management for institutions (other than insurance institutions) offering only islamic financial services.” Standard IFSB-1. December 2005. Online at: www.ifsb.org/standard/ifsb1.pdf
  • Sundararajan, V., and Luca Errico. “Islamic financial institutions and products in the global financial system: Key issues in risk management and challenges ahead.” Working paper WP/02/192. International Monetary Fund, November 2002. Online at: www.imf.org/external/pubs/cat/longres.cfm?sk=16109.0

Websites:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI): www.aaoifi.com
  • Bank for International Settlements (BIS): www.bis.org
  • Islamic Financial Services Board (IFSB): www.ifsb.org

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