Islamic Banking and Basel II1
Prepared by: Prof. Stefano Miani2 and Demeh Daradkah3
Abstract:
Thirty-three years ago Islamic banking was considered wishful thinking.
However, serious research work over the past two-and-a-half decades has shown
that Islamic banking is not only feasible and viable, but is an efficient and
productive way of financial intermediation. A number of Islamic banks have also
been established during this period in heterogeneous social and economic
milieus. Many challenges still lie ahead, however, for Islamic banks to be able to
comply with international standards and guidelines. A key issue relates to the
implementation of Pillar 1 of the Basel II Accord, or capital adequacy
requirements. The objectives of this paper are to provide a basic understanding
of the fundamental features of Islamic banking with a view of their history,
growth and development and to study the implications of applying Pillar 1 to
Islamic banks.
Keywords:Islamic Banking, Growth and Development, Regulation and
Supervision, Capital Adequacy Requirement, Risk–weighting and Basel II
Accord.
Introduction:
Islamic banking started on a modest scale in the early 1970s and has
shown tremendous growth over the last 30 years. What started as a small rural
banking experiment in the remote villages of Egypt has now reached a level,
where many mega-international banks are offering Islamic banking products.
The practice of Islamic banking now spreads from East to West, all the way
from Indonesia and Malaysia towards Europe and the Americas. The size of the
industry that amounted to a few hundred thousands of dollars in 1975 had
reached hundreds of billions of dollars by 2008. Like other banks, they are
profit-seeking institutions. However, they follow a different model of financial
intermediation. The fascinating features of that model have attracted worldwide
attention. While it is the preferred way of banking for one-fifth of humanity, it
offers a wider choice of financial products to all.
Submission to the second conference for the faculty of Business (University of Jordan),”Critical Issues for Emerging
Economies in Today’s Business Environment”, April 14 th-15th 2009
1
2
Faculty of Economics, University of Udine, Italy and Center for the Study of Financial Systems and Firms
in Central and Eastern Europe Countries, University of Udine, Udine, Italy. (E-mail:
Stefano.miani@uniud.it)
3
PHD student in Business Sciences, University of Udine, Udine, Italy. ( E-mail: Dima_Daradkeh@yahoo.com)
In a global world economy, however, Islamic banks have to face key
challenges in order to effectively compete with conventional banks. As of
January 2008, commercial banks in OECD countries started implementing the
Basel Committee on Banking Supervision’s accord (BCBS) on the Amendment
to the Capital Accord to Incorporate Market Risks4 and on the International
Convergence of Capital Measurement and Capital Standards: A Revised
Framework5, hereby referenced as Basel II Accord, which set standards for
capital adequacy and sound banking practices. This implies that eventually,
Islamic banks will need to follow up quickly and abide by international
standards as well. Capital adequacy has become the keystone for safety that
reflects supervisory concerns. The adoption of international standards by
Islamic banks will help enhance their credibility and fuel their growth
worldwide.
Under the standardised framework, Basel II sets clear guidelines for the
calculation of adequate capital. The balance sheet underlying the rules of the
Basel Capital Accords, however, belongs to a conventional bank whose structure
completely differs from that of an Islamic bank, both in terms of assets and
liabilities. No specific requirements addressing the particularity of Islamic
banks’ balance sheet structure were introduced under Basel II. As a result of the
particular nature of their activities, the risks borne by Islamic banking
institutions differ to a greater or lesser extent from those outlined in Basel II.
Serious attempts are being made by the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services
Board (IFSB) to develop a better capital adequacy framework that addresses the
risk profile of Islamic banks. (Turk and Sariedddine 2007)
This paper provides a basic understanding of the fundamental features of
Islamic banking with a view of their history, growth and development. After
4
5
BCBS (2001) and BCBS (1996).
BCBS (1988)
more than quarter of a century of practice, it is time to evaluate this experience.
And it also addresses primarily the crucial question of how to apply the
international regulatory standards to Islamic banks, the paper reviews the
applicability of Pillar 1 set by the Basel Committee for Banking Supervision on
Islamic banking. It finds that pillar 1 of the new Basel framework, namely
capital adequacy to be relevant to Islamic banks. It argues that adoption of the
new system for risk-weighting of assets proposed by the BCBS can help cultivate
an effective risk management culture in Islamic banks through internal ratings
and proper control systems. The paper argues that it will be easier for these
banks to adopt international standards if separate capital standards are set for
demand and investment deposits. This will enhance the endorsement of Islamic
banking by international standard setters, thus promoting its worldwide
acceptance and enabling it to compete successfully in a globalise environment.
The rest of the paper is organized as follows: the next section offers a brief
review of the History and Growth of Islamic banks and Financial Services. The
subsequent section provides the latest size of Islamic financial industry while
focusing more on Islamic banking, as it’s the main player of the industry. The
later Section provides a basic understanding of the fundamental features of
Islamic banking with a view to defining a paradigm version of Islamic banking
and characteristics of banks operating according to it. Based on this
understanding Section Four examines the crucial question of how to apply the
international regulatory standards to Islamic banks, focusing on the implications
of applying Pillar 1 of Basel II accord to Islamic banks. The paper concluded
with a section on policy recommendations.
1. Histories and Growth of Islamic Banks and Financial Services:
Although many factors appear to have led to the emergence of Islamic banks, the
most important of them could be the following:
(i)
Neo-Revivalist condemnation of interest as riba, Islamic banking
theory was being developed under the influences of neo-revivalist
thinking until Islamic banks began to be established on a large scale in
the 1970s.
(ii)
The oil-wealth of conservative Gulf States, the accelerated growth of
Islamic banks at national and international levels occurred after the
oil price rises of 1973 and 1974. Almost all Islamic banks established in
the 1970s in the Middle East were partly, and in some cases totally,
funded by oil-linked wealth. The most active countries in contribution
the necessary capital for Islamic banks, at private or public sector
levels, were Saudi Arabia, Kuwait and the United Arab Emirates
(UAE). The four hundred percent increase in the oil price after the
Arab oil embargo of 1973 was the important determinate in the
revenue increase for these countries. This increase in revenue created
large foreign reserves, the increase was beyond their absorptive
capacity, which led to a problem of the recycling of “petro-dollars”.
(iii)
The adoption of the traditional interpretation of riba by several
Muslim states at policy-making level, the political decisions relating to
its promotion are manifest on three fronts: 1-the prohibition of
interest in the laws of some Muslim countries; 2-the decision to
establish an international Islamic bank; 3-the participation of Muslim
governments in the emerging Islamic banking movement. (Saeed 1996)
1.1 Modern History of Islamic Banking and Financial services:
For the sake of minimizing the historical details, further discussion on the
history of Islamic economic and finance is limited to the developments since the
nineteenth century. One can divide the developments and efforts made toward
implementing a Shariah-compliant economic, financial and banking system into
three phases; pre-1950, 1950-1990 and from 1990 to the present.
1.1.1 Phase I: Pre-1950
Modern banking system was introduced into the Muslim countries at a
time when they were politically and economically at low ebb in the late
nineteenth century, where several Muslim countries were under colonies rule of
different rules through the nineteenth century and through a good part of the
twentieth century.
The main banks in the home countries of the imperial powers established local
branches in the capitals of the subject countries and they catered mainly to the
import export requirements of the foreign businesses. The banks were generally
confined to the capital cities and the local population remained largely
untouched by the banking system. The local trading community avoided the
“foreign” banks both for nationalistic as well as religious reasons. However, as
time went on it became difficult to engage in trade and other activities without
making use of commercial banks. Even then many confined their involvement to
transaction activities such as current accounts and money transfers. Borrowing
from the banks and depositing their savings with the bank were strictly avoided
in order to keep away from dealing in interest, which is prohibited by religion.
With the passage of time, however, and other socio-economic forces demanding
more involvement in national economic and financial activities, avoiding the
interaction with the banks became impossible. Local banks were established on
the same lines as the interest-based foreign banks for want of another system
and they began to expand within the country bringing the banking system to
more local people. As countries became independent the need to engage in
banking activities became unavoidable and urgent. Governments, businesses and
individuals began to transact business with the banks, with or without liking it.
(Abdul Gafoor 1995).
A formal critique and opposition to the element of “interest” started in
Egypt in the late nineteenth century when Barclays Bank was established in
Cairo to raise funds for the construction of the Suez Canal. The establishment of
such an interest-based bank in a Muslim country evoked opposition from its
inception. Further, a formal opposition to the institution of “interest “can be
found as early as 1903 when the payment of interest on post office saving funds
was declared contrary to Islamic values and therefore illegal by Shariah scholars
in Egypt. In India, a minority community of Muslims in southern India took the
first step toward their desire to purse an Islamic mode of economic activities by
establishing interest-free loans as early as in the 1890s. Another such institution
called Interest Free Credit Society was also established in Hyderabad in India in
1923.
During the first half of the twenties century, there were several attempts
to highlight the differences between the emerging conventional economic system
and the areas it conflicted with Islamic values. The need for an alternative
economic system conforming to the principles of Islam soon came to the fore and
econometrics began to lie out alternatives to the conventional banking system by
exploring Shariah –compliant contracts, especially equity partnerships. The
earliest references to the reorganisation of banking of profit sharing rather than
interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948). By the end of
1950s, Islamic scholars and econometrics started to offer theoretical models of
financial intermediation as a substitute to interest –based banking.
1.1.2 Phase II: 1960s-1980s
By the start of the 1960s, there was enough demand for Shariah-compliant
banking and it resulted in establishment of the Mit Ghamr Local savings Bank
in (1963-1967) by the noted social activist Ahmad-Al-Najjar, the bank proved to
be a huge success with accounts and deposits swelling within a short period of its
existence. However this experiment led to the creation of the Nasser Social Bank
in Egypt 1971 as an example of the first state sponsorship in the establishment of
an interest-free institution.
In the meanwhile there were a parallel efforts in Malaysia in 1963, where
the Malaysian government set up the “Pilgrim’s Saving Corporation” to help
prospective pilgrims to save and profit, which was latter incorporated into the
Pilgrims’ Management and Fund Board in 1969.
Islamic banks began to be established on a large scale in the 1970s, largely due to
the huge increase in the revenue of several oil-rich Muslim countries, especially
in the Middle East as a result of the oil price rise during that decade and the
growing influence of neo-revivalism.
In 1970, Muslim heads of state held a meeting in morocco to create what
later became the organisation of Islamic Conference (OIC), where it was decided
that Muslim governments should consult together with a view to promoting close
co-operation and mutual assistance in the economic, scientific, cultural and
spiritual fields.
Two more conferences where held in Jeddah March 1970 and the second
one in Karachi December 1970. Following these two conferences an important
meeting in Cairo 1972 were held to arrive at an alternative Islamic method of
dealing with financial matters and to find ways of facilitating the investment of
the surplus capital of the oil-rich Muslim countries in a way which would be of
benefit to the Muslim community. At that meeting an important document called
the Egyptian study6 were discussed. And it is also further discussed in the third
conference in Jeddah 1972.
In 1975, The Islamic Development Bank was established as an
international financial institution in pursuance of the Declaration of Intent
issued by the Conference of Finance Ministers of Muslim Countries held in
Jeddah in 1973, with the object of promoting economic development and social
progress as well as offering development finance of member countries (The
present membership of the Bank consists of fifty-six counties) and Muslim
6
It is an important document, Institution of an Islamic Bank, Economics and Islamic Doctrine.
communities individually as well as jointly in accordance with the principles of
Shariah .
Followed with the establishment of the Dubai Islamic bank by some
traders in 1975as one of the earliest private initiatives in the UAE. Academic and
research activities were launched with the first international conference on
Islamic economics held in Makkah, Saudi Arabia 1976.In Jeddah, Saudi Arabia
1978, the first specialized research institution, namely the Centre for Research in
Islamic Economics was established at the King Abdul Aziz University.(Saeed
1996)
The major developments of the 1980s include continuation of series
research work at the conceptual and theoretical level. As a result the Islamic
Research and Trading Institute was established in 1981by the Islamic
Development Bank. Where the Islamic republics of Iran, Pakistan and Sudan
announced their intentions to transform their overall financial systems to make
them compliant with the shariah. Other countries such as Malaysia and Bahrain
started Islamic banking within the framework of the existing systems.
In the early stages of 1980s the increased demand attracted the western
banks in different ways: first, the lack of quality investment opportunity in
Islamic banks created business opportunities for the conventional banks to act as
intermediaries to deploy Islamic banks’ funds according to the guidelines given
by the Islamic banks. Secondly, western banks started to offer Islamic products
thought Islamic windows7 in an attempt to attract the clients directly, without
having an Islamic bank as intermediary. Finally, non-western conventional
banks also started to offer Islamic windows because of the growing demand for
shariah-compliant product and the fear of losing depositors.
1.1.3 Phase III: 1980s-present
7
Are not independent financial institutions but are specialized set-up within conventional financial
institutions that offer shariah –compliant products for their clients.
By the early 1990s, the market had gained enough momentum to attract
the attention of public policy makers and of institutions interested in introducing
innovative products. The following are some of the noteworthy developments:
 Recognizing the need to present adequate, reliable and relevant
information to users of the financial statements of such organizations had
lead to seek the most appropriate financial accounting standards. The
interest in developing financial accounting standards for Islamic banks
started in 1987. In this respect, several studies have been prepared. These
studies have been compiled in five volumes and deposited in the Library
of the Islamic Research and Training Institute of the Islamic Development
Bank. The outcome of these studies has been the formation of the
Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI), which was registered as a not-for-profit organization in the
State of Bahrain in 1991. Since its inception the Organization has
continued the efforts to develop accounting standards.
 Islamic equity funds were established.
 Islamic Financial Services Board (IFSB) was established in 2003 to serve
as an international standard-setting body of regulatory and supervisory
agencies that have vested interest in ensuring the soundness and stability
of the Islamic financial services industry, which was defined broadly to
include banking, capital market and insurance. In advancing this mission,
the IFSB promoted the development of a prudent and transparent Islamic
financial services industry through introducing new, or adapting existing
international
standards
consistent
with
Shariah
principles
and
recommend them for adoption.
 Further progress was made in developing capital markets such as Islamic
assets-backed certificates, Sukuks (Islamic bonds), which were introduced
in the market
 During the equities market boom of the 1990s, several equity funds based
on Shariah-compatible stocks emerged. Dow Jones and Financial Times
launched Islamic indices to track the performance of Islamic equity funds.
 Several international infrastructure institutions were established to create
and support the Islamic financial system such as the International Islamic
Financial Market (IIFM), the General of Islamic Banks and Financial
Institutions (CIBAFI) that was established in 2008 and the Arbitration
and Reconciliation Centre for Islamic Financial Institutions (ARCIFI). As
well as other commercial support institutions such as the International
Islamic Rating Agency (IIRA), which was established in 2005, and the
Liquidity Management Center (LMC).
The systemic importance of Islamic banks and financial institutions has
been recognized in several jurisdictions. The Governments of United Kingdom
and Singapore extended tax neutrality to Islamic financial services. (Iqbal and
Mirakhor 2007).
2. The Size of the industry:
Until now, accurate figures across the entire Islamic financial institutions,
covering the entire range of geographies. Estimates of market size have varied
considerably and no verifiable source could provide a reliable global overview of
this growing industry. Based on information scattered over a number of
different sources, some observation can be made about the present size of the
Islamic Financial Institutions.
As Table 1 shows that in 2007 there were 525 Islamic Financial
Institutions contains of 292 Islamic banks, both fully Islamic and those offering
Islamic windows or selling Islamic products, 115 Islamic investment banks and
finance companies and 118 insurance companies. Operating in 47 countries
although mostly were in Muslim countries, there were some in Western Europe,
North America and Asia and it showed that the Islamic finance was growing at
almost twice the rate of western (interest-related) financial services and more
disclosure was expected to reveal even higher rates of expansion.
Table 1: Highlights on Islamic Financial Institutions in 2007
Number of Countries
47
Number of Shariah Institutions8
362
Number of fully Islamic banks
129
Number of investment banks and finance companies.
115
Number of insurance companies
118
Number of conventional institutions with Shariah 163
windows
Total
525
Source: The Banker, UK 2007
Based on the latest official figures9 the global total of Shariah-compliant
assets grew by 29.64 percent over the past year to reach USD 500.481.880 million
and by analysing the USD 500.5 billion global markets, the six states of the Gulf
Cooperation Council (GCC)(Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and
the United Arab Emirates) provide the largest portion of the overall global total
(35.6%) but the non-GCC Middle East and north Africa (MENA) states are not
far behind presenting 35.3%of the total, Asia is the third largest region with
23.8 % of the global market, where its most portion comes from Malaysia,
Brunei and Pakistan. Australia, Europe and America represent 4.3% of the
8
It represents the sum of the number of fully Islamic banks, number of investment banks and finance
companies and the number of insurance companies.
9
Based on the top 500 Islamic Financial Institutions list made by The Banker, UK, 2007.
total, where the smallest portion comes from sub Saharan Africa representing
0.9% of the global market. (Figure 1)
Figure 1: Global Market Share of Shariah –Compliant Assets in 2007
Global Market Share of Shariah-Compliant Assets
Australia/Europ
e/America
4,3%
Asia
23,8%
Sub-Shaharan
Africa
0,9%
GCC
35,6%
Non-GCC
MENA
35,3%
,
Source: The Banker, UK 2007
Table 2: Global Growth of Shariah-Compliant Assets
Region
2007(in
$)
Million 2006(in
$)
GCC
178.129.550
127.826.550
39.35
Non-GCC MENA
176.822.170
136.157.640
29.87
Total MENA
354.951.720
263.984.190
34.46
Sub-Saharan Africa
4.707.980
3.039.320
54.90
Asia
119.346.460
98.709.560
20.91
Australia/Europe/America 21.475.720
20.300.240
5.79
Global Total
386.033.310
29.64
500.481.880
Source: The Banker, UK 2007
Million % Of Growth
As it is indicated in Table 2, the overall total grew by 29.64 percent in
2007 to reach USD 500.481.880 million, the GCC institutions expanded the most
by 39.35 percent to reach USD 178.129.550 million and the non-GCC MENA
institutions grew by 29.87 percent to reach USD 176.822.170 million. Asia is the
third largest region in the world growing by 20.91 percent to reach USD
119.346.460 million.
The grouping of institutions from Australia, Europe and North America
accounts for USD 21.475.720 million, where Sub-Saharan African institutions
accounting for USD 4.707.980 million.
Analyzing Table 310, the country with the highest level of Shariahcompliant assets is undoubtedly Iran, which tops the country ranking with assets
of USD 144.616.280 million. Iran, which claims that its financial institutions are
100 percent Shariah compliant, has more than double the amount of its nearest
competitor, Saudi Arabia with USD 69.379.150 million and Malaysia with USD
65.083.370 million. This is because Saudi Arabia and Malaysia Shariahcompliant assets as a percentage of total assets are only 31.6 and 25.1 percent,
respectively.
Also the Top Fifteen countries list includes UK, a non Muslim nation in
the 10th place with Shariah –compliant assets of USD 10.420.470 million, which is
mostly came from HSBC Amanah, with a total of USD 9.725.000 million. The
UK’s extensive financial services capability and government support for Islamic
finance is moving London towards becoming a major hub for Islamic financing
on a global scale. There is also growing competition between Malaysia, Bahrain
and Dubai, which they are also promoting their credential as Islamic finance
hubs.
10
Table 3 and 4, based on data from “The Banker, UK, 2007”
Looking at Table 4, the Islamic banks dominate the list, where there were
19 Islamic bank either full-fledged or windows from the top twenty institutions.
The Iranian banks dominate the top positions accounting for six of the top
twenty places. Brunei-based insurance company Takaful IBB comes third with
USD 31.535.190 million, followed by Saudi Arabia with four banks, three from
Malaysia, two from UAE, one from Kuwait, one from Lebanon, the UK’s HSBC
Amanah in the 14th place and one bank from Bahrain.
2.1 Islamic Banks:
In the past two decades, Islamic banks have recorded high growth rates
both in size and number around the world. It is the fastest growing segment of
credit market in Muslim countries. The market share of these banks has risen
from 2 percent in the late 1970s, to about 15 percent in the mid 1990’s, as
measured by assets in the banking system. Conventional commercial banks have
also started to offer Islamic financial contracts. Many bankers predict that
Islamic banking could be responsible for management of over 50 percent of
saving in the Islamic countries in next decade. Islamic banks operate in over
sixty countries, most of them in the Middle East and Asia. In three countries,
Iran, Pakistan and Sudan, the entire banking system has been converted to
Islamic banking. In other countries, the banking systems are still dominated by
conventional banking institutions operating alongside Islamic banks. Calculating
the exact size of the Islamic banking sector is difficult but according to our
sources the total assets of Islamic banks was USD 250 billion and the total
Islamic banking windows was USD 200 billion in the year 2005.
Islamic banks have come a long way in a relatively short time and have
captured a significant market share from their conventional rivals. Some of the
penetration rates of Islamic banking services in Muslim countries are 5% in
Malaysia, 12% in Saudi Arabia and 30% in Kuwait it is anticipated that the
Islamic banking industry will be responsible for managing at least 40-50% of the
total savings of Muslims worldwide in 8 to 10 years. (Zaher and Hassan 2001)
The activities of Islamic banks tend to reflect the conditions of the country
in which they are based. There are strong operations in GCC and Malaysia
regions, where there are seventeen commercial banks offering Islamic banking
in the GCC countries (excluding Oman, where their government discouraged
Islamic banks) in Kuwait, well-established Islamic financial institutions have
been involved in substantial financing for the petroleum sectors and real estate
investment and in UAE the emphasis is on trade finance. Bahrain, on the other
hand, has enjoyed some success in marketing
Table 3: The Top Fifteen Countries by Shariah-Compliant Assets in 2007
Country
Shariah-Compliant Assets (in Million
USD)
Iran
154.616.280
Saudia Arabia
69.379.150
Malaysia
65.083.370
Kuwait
37.684.470
Brunei
31.535.190
Unites Arab Emirates
35.354.360
Bahrain
26.251.860
Pakistan
15.918.210
Lebanon
14.315.820
United Kingdom
10.420.470
Turkey
10.065.960
Qatar
9.459.710
Bangladesh
4.331.900
Egypt
3.852.860
Table 4:The Top Twenty Institutions by Shariah-Compliant Assets in 2007.
Institutions
Country
Shariah-Compliant
Assets in Million USD
Bank Melli Iran, Tehran
Bank
Tehran
Saderast
Iran
35.493.320
Iran, Iran
34.840.090
Takaful IBB Berhad
Brunei
31.535.190
Al Rajhi Bank
Saudi Arabia
28.093.120
Bank Mellat, Tehran
Iran
25.128.620
Amislamic Bank Berhad
Malaysia
22.263.250
Kuwait
Safat
Finance
House, Kuwait
Bank Tejarat, Tehran
Dubai
Dubai
Islamic
Iran
Bank, UAE
21.836.220
18.945.380
17.544.980
Bloom Bank
Lebanon
14.219.780
Bank Sepah, Tehran
Iran
13.913.530
Parisian Bank
Iran
10.483.100
Abu Dhabi Islamic Bank
UAE
9.881.670
HSBC Amanah
UK
9.725.000
National
Commercial Saudi Arabia
Bank Ltd, Jeddah
9.175.970
Bank Rakyat
Malaysia
7.784.770
AL Baraka banking group
Bahrain
7.625.830
Banque Saudi Fransi
Saudia arabia
7.302.540
Maybank
Malaysia
6.290.068
Samba Financial Group
Saudi Arabia
5.911.880
Itself as the region’s financial center because of its internationally
respected regulatory system where in Bahrain there is a greater emphasis on
investment banking. On the other hand, in Malaysia both systems work together
they have sixteen commercial banks offering Islamic banking and it focuses its
goals towards harnessing information technology to enhance efficiency and on of
the factors showing that the financial system is working efficiently is their
National Economy Policy. This model is revised each decade to ensure the
transformation has not hindered its progress.
According to data collected by the International Association of Islamic
Banks (IAIB) listed in Table 5, there were more than 176 financial institutions in
the public and private sectors of both these groups of Muslim and non-Muslim
countries by 1997, where nine were in Europe and America, forty-seven in the
Middle East (including twenty-one in the GCC countries), thirty-five in Africa
and eighty-two in Asia, where thirty-one were in South East Asia and fifty-one
where in South Asia).
Table 5: Growth of Islamic Financial Institutions (in thousand of US$)
Region
South
Asia
No. of 51
Shares
No. of 29
Share(
%)
Capital 884.0
48
Capital 12
(%)
Total
39.27
Assets 2.976
Total
26
Assets(
%)
Deposi 25.66
ts
4.913
Deposi 23
ts(%)
Reserv 1.077.
es
163
Reserv 35
es(%)
Net
249.7
Afric
a
G.C.C
Europe/A As
merica
ia
Austr Total
alia
35
South Middl
East
e East
Asia
31
26
21
9
2
1
176
20
18
15
12
5
1
0
100
202.1
97
3
149.8
37
2
3.684.
136
50
1.787.
395
24
616.795
3.4 5.21
52 9
0
0
7.333.0
79
100
1.573
.846
1
2.332
.204
2
83.13
6.100
56
20.44
9.637
14
908.922
5.7 5.59
27 0
0
0
147.68
5.002
100
730.0
25
1
1.887
.710
2
69.07
6.443
61
14.08
8.581
12
1.139.541 2.5 NA
63
1
0
0
112.58
9.776
100
82.08
7
3
160.1
36
5
382.2
86
12
1.353.
167
44
20.613
24
50
1
0
0
3.075.5
26
100
19.75
45.65
252.1
603.6
66.707
28
224
1.238.2
0
1
Profit
Net
Profit(
%)
92
20
0
2
9
4
85
20
42
49
5
2
0
0
41
100
Table 6: Growth of Islamic Financial Institutions (000 US $)
A. Aggregate Size Year-wise
Year No.
Of Combined
banks
Capital
Combined
Assets
Combined
Funds Under
Managemen
t
41.587.332
199 100
2.390.259 53.815.280
3
199 133
4.954.007 154.566.911 70.044.222
4
199 144
6.307.816 166.053.158 77.515.832
5
199 166
7.271.003 137.132.491 101.162.943
6
199 176
7.333.079 147.685.002 112.589.776
7
B. Sector Financing (% of total financing)
Year Trading
Agricultur Industry
Services
e
199 30.50
13.30
30.10
11.40
3
199 26.96
13.32
27.54
14.79
4
199 29.81
8.53
18.91
13.10
5
199 31.17
7.50
18.82
13.17
6
199 32.00
6.00
17.00
12.00
7
C. Modes of Financing (% of total financing)
Year Murabah Musharaka Mudaraba Ijarah
a
h
199 41.54
8.17
12.56
8.70
4
199 45.58
8.72
15.25
9.72
5
Combine
d
Reserves
Combine
d
Net
Profit
NA
NA
2.238.413
809.076
2.918.995
1.245.493
5.745.765
1.683.648
3.075.526
1.218.241
Real
Estate
NA
Others
5.44
11.96
12.10
17.13
11.67
17.67
16.00
16.00
Others
26.79
21.06
14.70
199 40.30
7.20
12.70
11.50
28.30
6
199 37.00
19.00
6.00
9.00
29.00
7
Source: International Associations of Islamic Banks (1997); (Zaher and Hassan
2001)
As Table 6 indicates, that they had a capital of USD 7.3 billion and
reserves of USD 3.1 billion. Their assets and deposits amounted to USD 147.7
billion and USD 112.6 billion, respectively.
During 1997, these institutions made a net profit of USD 1.2 billion. The ratio of
their net profit to capital and assets was 23.1 and 1.2 percent, respectively. While
most variables have registered a relatively high rate of growth, their capital and
reserves have not; they declined from 9.5 percent to 7 percent of their assets
(unadjusted for their risk ness) in 1997 because they where affected by the East
Asia crisis.
It has been noticed that trading, agriculture, industry, services, real estate and
others represent 30.08, 9.73, 22.47 12.89, 11.30 and 15.49 percent of total
financing, where Murabaha, Musharaka, Mudarabah, Ijarah and others
represent 41.11, 10.77, 11.63, 9.73 and 26.29 percent of total financing.
3.Islamic Financing:
Before the first Islamic bank was established, the understanding of Islamic
banking relied mainly on theoretical models developed by a variety of scholars.
Now, theoretical contributions as well as real-life practices of Islamic banking
have clarified the picture. The following discussion brings forward the most
important facts associated with Islamic banks. They provide the reader with a
taste of the mainstream thinking among Islamic economists and bankers.
3.1 Definition:
An Islamic bank is defined as a deposit-taking banking institution whose main
business is to mobilize funds from savers and supply these funds to
individuals/entrepreneurs whose scope of activities includes all currently known
banking activities, excluding borrowing and lending on the basis of interest. It is
managed by shareholders through their representatives on the board of
directors. (Bank Negara Malaysia, 2005)
3.2 Principles of Islamic Banks:
In general, the principles of Islamic banking are:
a. The prohibition against the payment and receipt of fixed or predetermined
rate of interest (Al Riba) and replace it with profit-and-loss-sharing (PLS)
arrangement where the rate of return on financial assets held in banks is not
known and not fixed prior to the undertaking of the transaction. The actual rate
can be determined only ex post, on the basis of actual profits accrued from real
sector activities that are made possible through the productive use of financial
assets.
b. The prohibition of unproductive speculation or unearned income (Al Maysir11)
as well as gambling (Al Quimar).
c. Freedom from excessive uncertainty.
11
Maisir refers to gambling and to any form of business activity where monetary gains are derived from
mere chance, speculation and conjecture. For example uncertainty of the timing of benefits in a pure life
insurance contract creates an element of maisir. The basis of compensation must be clearly pre-defined. In
its absence, the proceeds of a life insurance policy may not relate to premiums paid up to the date of death.
d. The prohibition of debt arrangements - most Islamic economic institutions
advise participatory arrangements between capital and labor. The latter rule
reflects the Islamic norm that the borrower must not bear all the cost of a
failure.
e. Al Zakat (the 4th pillar of Islam). One of the most important principles of
Islam is that all things belong to God, and that wealth is therefore held by
human beings in trust. The word zakat means both 'purification' and 'growth'.
Our possessions are purified by setting aside a proportion for those in need.
(Segrado, 2005)
f. Requirement to operate through Islamic modes of financing, these modes can
be divided into two groups: the ones that are based on the PLS principles (core
modes)[Mudarabah and Musharaka] and the ones that are not (marginal modes)
[Murabaha, Ijarah and Ijarah wa-Iqtina and Istinsa]. Table 7, provides a
summary description of the main features of both groups
Table7: Islamic Modes of Financing.
Type
Description
Comments
PLS Modes
Profit and Loss Sharing At the core of Islamic
Modes
Mudarabah
Finance Contract)
Banking
(Trust The bank provides the Three conditions need to
entire capital needed for be met:
financing a project, while
the entrepreneur offers his
labour
and
experience.
1. The bank should
not reduce credit
risk by requesting
collateral to this
purpose: it bears
entirely
and
exclusively
the
The profits (losses) from
the project are shared
between the bank and the
entrepreneur at a certain
fixed
ratio.
losses
Financial
are
born
exclusively by the bank.
The
liability
entrepreneur
of
is
the
limited
financial
risk.
Collateral may be
requested to help
reduce
moral
hazard, e.g., to
prevent
the
entrepreneur from
running away.
2. The rate of profit
has
to
be
determined strictly
as a percentage and
not as a lump sum.
3. The entrepreneur
has the absolute
freedom to manage
the business.
The bank is entitled to
only to his time and
receive
from
the
efforts. However, if the
entrepreneur the principal
negligence
or
of the loan at the end of
mismanagement
of
the
the period stipulated in the
entrepreneur
can
be
contract, if and only if a
proven he may be held
surplus
responsible
for
exists.
If
the
the
enterprise’s books show a
financial losses incurred.
loss,
It is usually employed in
investment projects with
short
gestation
and
in
commerce.
trade
periods
and
this
will
not
constitute default on the
part of the entrepreneur,
except for negligence or
mismanagement.
It affects both assets and
liabilities side of banks’
balance sheet. On the
liabilities
side,
the
contract between the bank
and depositors is known
as
unrestricted
Mudarabah
because
depositors agree that their
funds be used by the bank,
at its discretion, to finance
an
open-ended
list
of
profitable investments and
expect to share with the
bank the overall profits
accruing
to
bank’s
business. On the assets
side, the contact between
the bank and the agententrepreneur is known as
a restricted Mudarabah
because the bank agrees to
finance a specific project
carried out by a specific
agent-entrepreneur and to
share the relative profits
according to a certain
percentage.
Musharaka
(Equity The bank in not the sole Banks can exercise the
Participation Contracts)
provider
of
funds
to voting
rights
finance a project. Two or corresponding
to
of
their
more partners contribute share of the firm’s equity
to the joint capital of an capital
investment.
their
representatives can sit in
the
firm’s
board
of
invest
in
directors.
Profits (losses) are shared
strictly in relation to the All
respective
Parties
capital varying proportions and
have
contributions.
the
participate
management
It is usually employed to
finance
long-term
enterprise.
right
in
of
to
the
the
investment projects.
Muzar’ah
Traditional
counterparts
of Mudarabah contract in
farming.
The harvest is shared
between the bank and the
entrepreneur. The bank
may provide funds or
land.
Musaqat
Traditional counterpart of
the Musharaka contracts
in orchard keeping.
The harvest is shared
among the partners based
on
their
respective
contributions.
Direct investment
The same concept as in Banks can exercise the
conventional banking the voting
bank cannot invests in the corresponding
rights
to
their
production of goods and share of the firm’s equity
services, which contradict capital.
Their
the value pattern of Islam, representatives can sit on
the
such as gambling.
firm’s
board
of
directors.
Non- PLS Modes
Non
Profit
and
Loss They are used in cases
Sharing Modes
where PLS modes cannot
be implemented.
Qarad
These
are
zero-return
Hassana(Beneficence
loans
that
Loans)
exhorts Muslims to make
the
Quran
to “those who need them”.
Banks
are
allowed
to
charge the borrowers a
service fee to cover the
administrative expanses of
handling
the
loan,
provided that the fee is not
related to the amount or
maturity of the loan.
Bai’ Mua’jjal (Deferred The seller can sell a Contrary
Payment Sales)
product on the basis of a based
deferred
payment
to
on
contracts
the
PLS
in principles, modes such as
instalments or in a lump markup, leasing and lease
sum payment. The price purchase
have
a
of the product is agreed predetermined and fixed
upon between the buyer rate of return and are
and the seller at the time associated with collateral.
of the sale and cannot
include any charge for
In fact, banks add a
deferring payments.
Bai’ Salam or Bai’ Salaf The buyer pays the seller certain percentage to the
(Purchase with derfeeed the full-negotiated price of purchase
price
and/or
a product that the seller additional costs associated
delivery)
promises to deliver at a with these transactions are
future date. This mode a profit margin and the
only applies to products purchased assets serve as
whose
quality
and a guarantee. Additionally,
quantity can be specified banks may require the
at the time the contract is client to offer a collateral.
made. Usually, it applies
to
agricultural
or
These instruments can be
manufactured products.
considered to be more
Ijarah
(Leasing)
(Lease Purchase)
and A party leases a particular closely
associated
with
product for a specific sum risk aversion and they do
and a specific period of not
substantially
differ
time. In the case of a from those used in a
lease-purchase,
payment
includes
each conventional
banking
a system, other than their
portion that goes toward terminology and in some
the final purchase and legal technicalities.
transfer of ownership of
the product.
Murabaha (Mark-up)
The seller informs the They are considered to
buyer
of his cost
of conform
to
Islamic
acquiring or producing a principles because the rate
specified
product;
then of return is meant to be
profit margin (or mark-up) tied to each transaction,
is negotiated between the rather than to the time
buyer and the seller. The dimension.
total cost is usually paid in some
installments.
However,
Muslim
advocate
a
scholars
stricter
Jo’ala(service Charge)
A party undertakes to pay utilization
of
such
a
another party a specified modes.
amount of money as a fee
for rendering a specified
service in accordance to
the terms of the contract
stipulated between the two
parities.
This
usually
applies
transactions
consultations
professional
mode
such
to
as
and
services,
fund, placements and trust
services.
Source: Kazarian 1993, Iqbal and Mirakhor 1987, Errico and Farahbaksh 1998
and Zaher and Hassan 2001.
G .As a part of their mission, Islamic banks are encored to make charitable loans
(Qard Hassana) to individuals or organizations. These loans are zero return
loans, however, the banks are allowed to charge the borrowers a service fee to
cover the administrative expenses of handling the loan provided that the fees is
not related to the amount or maturity of the loan. These are clearly negative net
present value investments to Islamic banks and are not very common in most
Islamic countries.
3.3 Comparison of Islamic and conventional banking framework:
Table 8, provides a synoptic comparison of Islamic and conventional
banking frameworks. There are several points that are worth noting, first,
neither the capital value nor the return on investment deposits is guaranteed by
Islamic banks and these banks basically pool depositors’ funds to provide
depositors with professional investment management. This situation underscores
an interesting similarity between the operation of Islamic banks and investment
companies12. There is, however, a fundamental difference between the two that
needs to be recognized. It lies in the fact that investment companies sell their
capital to the public, while Islamic banks accept deposits from the public. This
implies that shareholders of an investment company own a proportions part of
the company’s equity capital and are entitled to a number of rights, including
receiving a regular flow of information on developments of the company’s
business and exerting voting right corresponding to their shares on important
matters, such as changes in investment policy. Hence, they are in a position to
take informed investment decisions, monitor the company ‘s performance and
influence strategic decisions. By contrast, depositors in an Islamic bank are
entitled to share the bank’s net profit (or loss) according to the PLS ratio
stipulated in their contracts.
Investment deposits cannot be withdrawn at any time but only on
maturity and in the best case at a par value. Moreover, depositors have no voting
rights because they do not own any portion of the bank’s equity capital. Hence,
they cannot influence the bank’s investment policy (as noted, their relationship
with the bank is regulated according to an unrestricted Mudarabah contacts).
Is defined as an entity that pools shareholders’ funds to provide them with professional investment
management.
12
Second, because of the structure of their balance sheet and the use of profit and
loss sharing arrangements, banks operating according to a paradigm version of
Islamic banking appear to be better poised than conventional banks to absorb
external shocks. Indeed as noted previously, these Islamic banks have the ability
to reduce the capital value of investment deposits in the case of a loss. Third,
Islamic banks are not expected to reduce credit risk by systematically requiring
a collateral or other guarantees as a pre-request for granting PLS facilities.
Fourth, a critical differences between the two permissible systems of operation
needs to be recognized. Islamic banks can use all of their deposits (demand and
investment) for their financing and investment activities in two-tier model, while
only investment deposits can be utilized for such purpose in two-windows model.
This makes two-tier model, where banks’ assets and liabilities are fully
integrated far riskier than two-window model, where banks’ liabilities are
divided into two windows. Indeed, in the first model-given the fact that (1)
demand deposits are guaranteed in capital value and are redeemable by the
depositors on demand, (2) demand deposits can be used to finance risk-bearing
investment projects and (3) there is not a mandated specific reserve requirement
on demand and investment deposits-an assets-liability mismatch can occur,
leading possibly to negative net worth or bank insolvency. (Errico and
Farahbaksh 1998 and Zaher and Hassan 2001)
The risk to which depositors may be exposed creates a greater need in he
Islamic banking system for providing a psychological reassurance to the
depositors about the health of the financial system. This demands, firstly, trust in
the macroeconomic health of the country’s economy and, secondly, confidence in
he safety and soundness of the financial system as well as the institutions with
which the depositors deal. The former can only be ensured by the pursuit of
healthy monetary, fiscal, and exchange rate policies, while the latter can be
ensured by the injection of greater market discipline in the banking business.
This needs to be further reinforced by prudential regulation and effective
supervision, with special stress on capital adequacy, proper risk assessment and
management, effective internal controls and external audit, and greater
transparency. It is also necessary to improve and streamline corporate
governance so that the funds received by firms from banks are more effectively
utilised for the ultimate benefit of both the financier and the user.
Table 8: Comparison of Banking Framework
Characteristics
Paradigm
Version
of Conventional Banking
Islamic Banking
Nominal value guarantee
of: Demand deposits
Yes
Yes
Investment deposits
No
Yes
Equity-based system where Yes
No
capital is at risk
Rate of return on deposits
Mechanism
to
Uncertain, not guaranteed
regulate Depending
final return on deposits.
on
Certain and guaranteed
banks’ No
performance /profits from
investment
PLS principle is applied
Yes
Irrespective
of
banks’
performance /profits from
investment
Use of Islamic modes of Yes
NA
financing PLS and nonPLS
Use of discretion by banks Possible
with regard to collateral
moral
for
hazard
reducing Yes always
in
PLS
modes
Banks’ pooling of deposits Yes
funds
to
professional
provide
No
with
investment
management
Source. Errico and Farahbaksh 1998.
4.Regulation and Supervision in an Islamic Framework:
Greater attention has been paid since the early 1990s to the regulatory
and supervisory framework covering Islamic Financial Institutions (IFI). Early
studies have raised the issues of regulation and supervision of Islamic Banks
such as Archer and Karim (1997), Archer, Karim and Al-Deehani (1998), where
their studies noted that an appropriate regulatory framework should place a
greater emphasis on accounting standards and information disclosure.
On the other hand, Errico and Farabakash (1998), suggested that an
appropriate regulatory framework for banking supervision in an Islamic
environment should be designed to ensure that: (a) legal foundations for the
supervision of Islamic banks are in place;(b) investment and other risks are
adequately dealt. (c) Adequate information is disclosed to allow the supervisory
authorities to exercise a more effective prudential supervision and to enable
public to make reasonably informed investment decisions. (d) A greater stress on
theses issues should be done during the licensing process, in order to strengthen
the financial system surveillance in countries where Islamic banking is followed.
Based on the standards and best practices established by the Basel Committee,
and an Islamic finance-tailored prudential framework based on the CAMEL13
system, where they emphasis on special issues for Islamic banks that need to be
taking into account to make Islamic banking supervision more effective, first, it
is important to recognize the impact of PLS modes of financing on Islamic
banks, there is no recognizable default on the part of the agent-entrepreneur
until contacts expire, where a default means that the investment project failed to
deliver what was expected, that is a lower or no profit or a loss. In this case, the
lower profit/loss is shared between or among parties according to the
predetermined PLS ratio. (a) In then case of Mudarabah contract, (1) the bank is
entitled to receive from the entrepreneur the principal of a loan at the end of the
period determined in the contact, if and only if, profits have occurred, if not the
enterprise’s books showed a loss, the bank would not be able to recover its loan.
(2) Entrepreneur would not normally constitute default because his liability is
13
It is a measure of the relative soundness of a bank and is calculated on a 1-5 scale, with one being a
strong performance. The acronym stands for Capital, Assets, management, earnings and liquidity.
limited to his time and effort. (3) Banks have no legal means to control the agententrepreneur who manage the business.
By contrast, Iqbal and Mirakhor 2007 implied that banks have both
direct and indirect control on the behavior of the agent-entrepreneur through
both explicit and implicit contracts. Banks can exert control through both the
formal terms of their contracts and through an implicit reward-punishment
system in the sense of refusing further credit or the blacklisting of the agent –
entrepreneur. To the extent that the reputation of firms and that of its managers
is important, this is a strong deterrent to irresponsible behavior. The nature of
the contacts permits the banks to focus their attention on the probability of
default and the expected rate of return, as also on the promotion and control of
the firms in which they invest. (b) In the case of Musharaka and direct
investment contracts, banks have better opportunities to monitor the business
they invest in. Second, the investment risk is the most critical operational risk
affecting the bank and the assessment and managing it is more difficult in
Islamic bank than conventional bank because of the following reasons: (1) in
Mudarabah contract, the bank cannot exert control on the management of the
investment project;(2) PLS modes cannot systematically be made dependent on
collateral or other guarantees;(3) administration of PLS modes is more complex
compared with conventional financing (4) the relatively weak legal mode
framework supporting bank lending operation.
Similarly Errico and Sundarajan (2002) reinforced this view by
recommending a regulatory framework created along the same lines as a
CAMEL framework and also suggested a suitable information disclosure
requirements which should be an integral part of the regulatory framework
coupled with appropriate accounting standards.
A recent study was made by Archer and Ahmed (2003) who suggested
special features of accounting, corporate governance and prudential regulations
for Islamic financial institutions. They also noted issues regarding the
applicability of the (International Accounting Standards) IAS to IFI and further
described the efforts undertaken by AAOIFI in creating accounting and auditing
regulations, standardizing Shariah interpretations and establishing capital
adequacy ratios for IFI.
An appropriate regulatory framework in an Islamic banking framework
is just as necessary as in conventional banking system, as in conventional
banking, an appropriate regulatory framework for an Islamic system should aim
at reinforcing banks’ operating environment, internal governance and market
discipline. To help develop such a regulatory framework, standards and best
practices established by the Basel Committee on Banking Supervision (BCBS)
are useful and provide a valuable reference. As of January 2008, commercial
banks in OECD countries started implementing the Basel Committee on
Banking Supervision’s accord on the Amendment to the Capital Accord to
Incorporate Market Risks14 and on the International Convergence of Capital
Measurement and Capital Standards: A Revised Framework15, hereby
referenced as Basel II Accord, which set standards for capital adequacy and
sound banking practices. This brings into focus the question of whether these
standards are adequate for Islamic banks or not?
The answer has to be positive even though on the face of it one may feel
differently. It may be argued that because investment depositors participate in
14
15
BCBS (2001) and BCBS (1996).
BCBS (1988)
the risk, Islamic banks should not be subjected to regulations any more than
normal corporations are. However, there is a significant difference. Firstly, there
are systemic considerations. While the failure of a corporation may affect
primarily its own shareholders, who are expected to be on the guard, the failure
of a bank has implications for the health and stability of the whole payments
system as well as the development of the economy. If depositors lose confidence
in the system, they will withdraw their deposits, which will not only destabilise
the financial system but also jeopardise their availability for financing
development. Secondly, there is the interest of demand depositors, which needs
to be safeguarded. However, investment depositors also need greater safeguards
than what shareholders do in normal non-bank corporations. This is because of
the significantly higher leverage in banking business. Such leverage would come
from demand deposits. The higher the proportion of demand deposits, the higher
would be the leverage. This would necessitate the adoption of certain procedures
by banks to prevent arbitrariness in investment decisions, mismanagement and
excessive risk exposure, and to manage prudently whatever risks they take. They
would also have to build adequate reserves to avoid excessive erosion of
investment deposits. Thirdly, it is also necessary to ensure the faithful
compliance of banks with the teachings of the Shariah. Fourthly, there is the
imperative of making Islamic banks accepted in the inter-bank market of the
international financial system. This will not happen unless they conform to
international regulatory standards. (Chapra and Khan 2000)
The next question that takes important concerns of regulators and
supervisors of Islamic banks is how to apply these standards to these institutions
while, simultaneously, enabling them to operate in conformity with the
Shariah?16 In view of the special nature of investment deposits and the risks
faced by the assets of Islamic banks, application of the international capital
16
This paper focused on pillar 1 of the accord.
adequacy standards to Islamic banks has become a challenging task. Since
capital adequacy is now internationally considered to be the core of systemic
safety and hence supervisory concerns, the fulfillment of this crucial
requirement will help enhance the credibility and growth of Islamic banking
worldwide. We briefly discuss this subject in this section while introducing
AAOIFI and IFSB proposals for developing a capital adequacy framework
applicable to Islamic banks.
4.1 The AAOFIF Proposal:
In 1999, the AAOIFI17 has promulgated a Statement on the Purpose and
Calculations of Capital Adequacy Ratio (CAR) for Islamic Banks. This was the
first initiative toward developing a tangible framework that properly addresses
the risk faced by Islamic bank. The document proposed a method for calculating
the CAR for Islamic banks. Much of the suggested methodology is based on
Basel II standards taking into account differences between deposit accounts in
conventional banking and investment accounts in Islamic banking.
Due to the discussion about Islamic banking, we conclude that its capital
is simple (as it does not contain hybrid instruments, subordinated debts and
other new forms of funds), in general the nature of demand deposits of these
banks is not different from that of conventional banks, the nature of investment
deposits is significantly different. However, according to AAOIFI 1999a
standards it requires Islamic banks to report these deposits on their balance
sheets, mostly unrestricted and have to be considered in the CAR.
On the other hand, in some cases these can also be restricted and included
as off-balance sheet item. The implication is that such investment funds will not
be included in the calculation of CAR.
17
For more details, see AAOIFI (1999).
Once investment deposits are shown on the balance sheet, there arises the
question of their position with respect to the fulfillment of capital adequacy
requirements?
According to AAOIFI 1999b standards it suggests that
capital as a common numerator for both demand and investment deposits, This
prompts us to first discuss these standards and then suggest for the consideration
of standard setters an alternative that requires separate capital numerator for
both these deposits.
4.1.1 Combined Capital Adequacy for Demand and Investment Deposits:
In this case the AAOIFI suggested two standards:
 The AAOIFI capital standards suggest a risk-sharing scheme between
investment deposits and the bank’s capital. Investment deposits share
with the bank capital the normal commercial risks of the bank’s
operations. It is argued that the bank's capital faces two types of risks in
the management of investment deposits. These consist of fiduciary risks
(refer to the probability of the bank being guilty of negligence or
misconduct in implementing the deposit (mudarabah) contract). The
depositors may as a result lose their confidence in the bank and withdraw
their deposits. And Displaced commercial risk (arises from the probability
of the bank not being able to catch up with other Islamic or conventional
banks in competition). Consequently, a certain proportion of its profits
attributable to shareholders may have to be diverted to investment
depositors to prevent the withdrawal of these deposits and, in an extreme
case, a run on the banks.
 The AAOIFI standards, therefore, suggest a scheme for the sharing of
risks between investment depositors and shareholders of the bank.
Accordingly, 50% of the risks of assets financed by investment deposits
should, as a rule of thumb, be assigned to investment depositors for the
purpose of capital determination, and the remaining 50% to shareholders.
Thus, the AAOIFI capital adequacy ratio is calculated as follow:
CAR 
Total _ Capital
RWAK &CA  50%RWAUIA 
Where RWA K&CA represents the average risk weighted assets financed
by the bank’s capital and depositors’ current accounts, and RWA UIA
represents the average risk-weighted assets financed by the unrestricted
depositors’ investment accounts.
This means that the risk of assets financed by investment deposits
(unrestricted accounts) will be assigned a weight of 50% for the purpose of
determining capital requirement (instead of 100 % as assigned by Basel II),
where Turk Ariss and Sarieddine 2007, Errico and Farabakash 1998 and
Chapra and Khan 2000 suggested that unrestricted account should carry the
same risk weighted assigned by Basel II of 100% because of the following
reasons: although unrestricted investment account holders share risks with bank
shareholders, their funds cannot be considered as equity. The rationale is that
investment depositors can withdraw their funds upon maturity and reduce the
sources of funds available to the bank, but the equity base remains unchanged
when shareholders ‘withdraw their funds’ by selling their shares to other
investors. Another reason that explains why unrestricted investment accounts
cannot be classified under equity or Tier 1 capital is that such account bearers
have no voting rights.
According to Chapra and Khan 2000, the AAOFI indeed a pioneering
task in the establishment of capital adequacy standards in which (1) it helps to
crystallize the differences between the capital of Islamic and conventional banks,
(2) it increases the transparency by requiring the banks to keep investment
deposits on their balance sheets (3) it has also highlighted the need to report the
assets of current and investment accounts separately, thus enhancing
information on exposures. On the other hand there are some contribution that
could be taken into account:
 It is indispensable for Islamic banks to adopt the accepted international
standards for the recognition of Islamic banking practices in the
international markets, where the primary concern is systemic stability.
 Although the risk-sharing nature of investment deposit will enhance the
market discipline and the soundness of the bank, it should be noted that
these deposits do not represent a permanent part of banks’ equity, where
their level depend on the soundness and profitability of the bank, in this
case they would absorb the losses to some extent. In contrast the equity
capital is available permanently and it would provide a strong shockabsorbing capacity. Adequacy of capital is hence important for Islamic
banks. It would serve as the foundation on which the strength and
soundness of these banks would ultimately depend.
 There should be some guarantee and safety for demand deposit is Islamic
banks, where the most suitable technique could be the Equity capital with
adequate loss-offsetting reserves. And it is recommended not to relay on
deposit insurance.
 Most Islamic banks are relatively very small in size. Since smaller banks
cannot diversify their assets portfolios as much as larger banks can do,
they need a larger amount of capital relative to their assets to inspire
confidence in their viability as well as their ability to maintain their core
operations over the longer term.
 Capital requirements also depend on the risk ness of the banks’ portfolio
of loans and investments, the more riskier the banks’ portfolio of loans
and investment, the greater the need for capital, taking into account that
PLS modes are more riskier than non PLS modes, The probability of
default also determines the quality of assets and therefore the size of
capital, and until a consensus is reached on the imposition of a penalty on
the defaulting party, banks may have to be required to hold more capital.
 The economic strength of the country concerned as well as its banks and
depositors is also a factor in determining capital requirements.
 The extent and nature of off-balance sheet items that the banks carry and
the risk concentration resulting there from are also important in
determining the extent of capital requirements.
4.1.2 Separate Capital Adequacy for Demand and Investment Deposits:
Another suggestion would be to adopt separate capital adequacy
standards for demand and investment deposits. This separation will serve the
objective of preventing the transmission of risks from investment deposits to
demand deposits and it will also enhance comparability, transparency, market
discipline, depositor protection and systemic stability.
4.2 The IFSB Proposal:
As a result of the meeting held in April 21, 2002 in Washington DC, which
was made at the sidelines of the IMF/ World Bank, a group of central bank
governors (Bahrain, Indonesia, Iran, Kuwait, Lebanon, Malaysia, Pakistan,
Saudi Arabia, Sudan and UAE, senior officials from the Islamic Development
Bank and the AAOIFI, Islamic Financial Service Board (IFSB) was established
in 2003 (as mentioned in section 1) and held in Kuala Lumpur, Malaysia to
promote good regulatory and supervisory practice and uniform prudential
standards for Islamic financial institution.
Like the AAOIFI proposal, the IFSB capital adequacy framework serves
to complement the Basel Committee on Banking Supervision's guidelines in
order to cater to the specificities of Islamic financial institutions. While the
AAOIFI focuses on the sources of funds of an Islamic bank, the IFSB, however,
goes a step further by considering the uses of funds and assigning appropriate
risk weights to each asset item. The major contribution of the IFSB is to
acknowledge that the uses of funds for Islamic banks, which are by nature
Shariah compliant, differ from the typical asset side of the balance sheet for a
conventional bank. The IFSB frame of work aims at:

Identifying the specific structure and contents of the Shariah-compliant
products and services offered by Islamic banks not considered under
Basel II or by the AAOIFI.

Standardising Sharia-compliant products and services by assigning risk
weights to those that meet internationally acceptable prudential
standards.

Setting a common structure for the assessment of Islamic financial
institutions' capital adequacy requirements.

Including market risk not only in the trading book but also in the banking
book of Islamic banks due to the nature of the banks' assets such as
Murabaha, Ijara, Salam, Musharaka and Mudarabah.
In December 2005, the IFSB issued the 'Capital Adequacy Standard for
Institutions (Other than Insurance Institutions) Offering Only Islamic Financial
Services'. The recent standard takes into consideration the specificity of
investment account holders who share part of the risk with shareholders as
follows:
CAR 
Tier1  Tier 2
RWACredit _ risk Market _ riskOperation_ risk  RWA _ founded _ by _ PSIACredit _ risk Market _ risk


Where RWA(Credit risk+Market risk+Operational risk) include those financed by both
restricted and unrestricted Profit Sharing Investment Accounts (PSIA). The
capital amount of PSIA is not guaranteed by the Islamic financial institution and
any losses arising from investments or assets financed by PSIA are to be borne
by the Investment Account Holders, and thus do not command a regulatory
capital requirement. This implies that assets funded by either unrestricted or
restricted PSIA should be excluded from the calculation of the denominator of
the capital ratio.
4.3 Level of Capital Adaquacy Ratio:
The risk-weighted capital adequacy ratio for an Islamic bank should be
higher than ratio (of at least 8 percent) set by the Basel II because of specific
reasons inherent to the operation of Islamic banking, as well as more general
reasons that are de-facto part of the high-risk environment in which most
Islamic banks operates. The specific reasons are the following:
1. Mudarabah contracts put depositors’ fund at risk but allow a portion of
profits to accure to banks’ owners. This creats a potentionally stong
incentive for risk taking and for operating financial institutions without
sutabile capital. Hence, to help reduce moral hazard, it would be more
important for the banker to have substantial amounts of his own capital
at risks.
2. the lack of control on investment projects in Mudarabah transaction and
the absence of collateral and other guarantees in PLS transactions clearly
raise the overall riskiness of Islamic banks’.
On the other hand, the factors contributed to the high –risk environment
of most developing and emerging market countries in which Islamic banks
operate are:
1. A relatively weak legal infrastructure supporting bank lending
operations.
2. Underdeveloped financial markets.
3. A volatile economic environment, contributed to an uncertain financial
condition in the enterprises.
4. The less diversified nature of the economy.
The assessment of an appropriate level of the capital adequacy ratio for
Islamic banks should be primarily based on a through analysis of the
composition of the underlying assets portfolio between PLS and non-PLS
transaction, which is very difficult to do due to the general lack of uniformity in
accounting standards, lack of data related provisions and differences in the tax
treatment of loan loss provisions and banks’ profits. Therefore it seems
appropriate to conclude that the assessment of an appropriate level of the capital
adequacy ratio for Islamic banks should be carried out on a bank-by-bank and
country-by-country basis. (Errico and Farabakash 1998)
4.4 Risk-Weighting Alternatives:
One of the most important features of Basel II is the significant change in
the risk weighting of assets for determination of capital requirements.
Depending on the supervisory assessment of banks’ risk management
capabilities, these changes would give the banks the option to adopt either a) the
Standardised Approach, b) Foundation Internal-Ratings Based Approach, or c)
the Advanced Internal-Based Rating Approach. The ultimate objective is to
develop risk management culture in banks by requiring lesser capital for the
adoption of appropriate policies by banks.
But what would be the best risk-weighting choice for Islamic banks?
Where the adoption of any one of these approaches will first depend on the
capabilities and preferences of banks and the subsequent supervisory review and
follow up. The following three considerations make it preferable for Islamic
banks to apply the internal ratings-based approach:
1. The difference in the nature of Islamic modes of finance makes the risks
of Islamic banks’ assets different from those created by interest-based
lending. This makes the risk-weighting system more complex in assessing
the quality of assets. This is because assets are not risk-weighted
individually in the old Basel system, but rather grouped and bucketed
according to the different risk categories. The internal ratings-based
approach removes this problem by requiring the probability of default
(quality) of each asset to be determined individually.
2. The internal ratings-based approach allows each bank to develop its own
risk management system. This will make it possible for Islamic banks to
develop systems, which can meet the peculiar requirements of the Islamic
modes of finance.
3. The diverse nature of Islamic modes of finance, inadequate development
of risk management systems and requirement for risk-sharing make it
incumbent upon Islamic banks to allocate more resources to risk
management as compared with their conventional counter-parts. Hence
the internal ratings-based approach seems to be most conducive to the
development of a risk management culture.
But one could ask, what are the benefits of applying the second approach
on Islamic banks? The answer would be that the adoption of the second
approach would increase the worldwide competitiveness of Islamic banks and
the acceptance from international standard setters. It will solve the problem of
complexity in assessing the quality of assets for Islamic banks and once these
assets are recorded according to their probability of default and maturity, it
would be possible to develop an index of the assets’ risks. This index could be
used to determine the capital requirement for each asset, to be aggregated
afterwards for determining the overall capital requirement. And finally the
adoption of this approach will strengthen the market discipline through the
disclosure of information about their capital adequacy policies and ratios.
Given the small size of most Islamic banks and their inadequate risk
management capabilities, it is not expected that many of them will be able to
initially qualify for the most desirable approach (internal ratings-based
approach). Therefore, most Islamic banks could initially be supervised within
the framework of the standardised approach. Where it handles the limitation of
the lack of ratings or external source of credit assessment for the clients of most
Islamic banks by allowing 100% risk-weight to assets for which no external
credit assessment is available. (Chapra and Khan 2000).
4.5 Other Proposals:
Other proposals are suggested for capital adequacy requirements and for
the risk management of Islamic banks. The idea is to put less emphasis than the
AAOIFI scheme on developing a framework that has basic similarities with
Basel II. One proposal is to ‘treat Islamic banks for regulatory purposes as
mutual funds, whose obligation is to repay not the original sum invested but that
remaining after taking account of gains or losses at the time of redemption’.
(Cunningham 2000) It can be argued, however, that such an approach will
underestimate the account holders’ perceptions of their deposits and
investments.
A Second proposal is to structure liabilities and assets along different
objectives following the risk appetite of account holders. (El-Hawary et al, 2004)
Funds belonging to account holders who have a high risk aversion and high
liquidity needs would be invested in asset-backed securities with a low risk and
acceptable marketability, while funds of account holders having a higher risk
appetite would be placed in light of their investment objectives.
A third proposal that has some support among regulators in the United
Kingdom is to involve the structuring of liabilities according to a scheme of
subordination of the rights of different categories of account holders. This would
lead to an appropriate categorisation of risks on the asset side and take into
account the actual risk experience of Islamic banks. (Davies 2004) These studies
are important contributions to the unexplored topic of how to account for the
risk exposure of Islamic banks and develop a reliable capital adequacy
framework. None suggest an approach, however, to deal with the specific nature
of Islamic banks assets and their related particular risks, probably due to the
lack of implementation of industry wide accepted standards for Islamic banking
practices. (Turk Ariss and Sarieddine 2007)
5. Policy Recommendations:
Throughout the past 30 years, the practice of Islamic banking has proved
to be a viable alternative and is growing at an estimated annual rate of 15
percent. The imperative of ensuring the viability, strength, and continued
expansion of these institutions and enhancing their contribution to financial
stability and economic development has recommended the following:
 More efforts must be made by the AAOIFI to enhance the produce of
uniformity accounting standards, where their work should be increasingly
published and discussed in international for a attended by also western
supervisors, representatives of the accounting and auditing professions
and interested potential counterparts.
 More efforts must be made to build a whole database system set for
Islamic financial industry.
 The risk-weighted capital adequacy ratio for an Islamic bank should be
higher than ratio (of at least 8 percent) set by the Basel II because of
specific reasons inherent to the operation of Islamic banking, as well as
more general reasons that are de-facto part of the high-risk environment
in which most Islamic banks operates.
 An appropriate risk-weighting structure for an Islamic system should
have the Mudarabah contracts carrying the highest risk weight, followed
by the two other main PLS modes, namely Musharaka and direct
investment. The lowest risk weight should be assigned to the non-PLS
modes fully secured by a mortgage. All the other non-PLS modes should
be assigned a risk weight somewhere in between the lowest one in the
system and the one assigned to Musharaka and direct investment.
 Unrestricted account should carry the same risk weighted assigned by
Basel II of 100%.
 This creates the need to establish an institution that would help set
regulatory standards and a framework for supervisory oversight for
Islamic financial institutions.
 There will also be the need to train Islamic bank regulators and
supervisors for developing effective internal rating and control systems
and risk management culture in these banks. This will, in turn, improve
the external rating of these banks and help them not only in utilising their
equity capital more efficiently but also in enhancing their growth and
stability.
 It is recommended that, even if the Islamic banks have to start with the
second best approach, it would be desirable for them to quickly graduate
into the first-best approach. As far as the advanced internal-rating based
approach is concerned, it is too early at this stage for Islamic banks to
fully rely on this approach. However, it would again be in the interest of
these institutions to start familiarising themselves with these approaches
and building the capability for the application of computer-based models.
 It is also necessary to remove the disadvantage of small size of Islamic
banks by encouraging and facilitating the merger of a number of such
banks so that an optimum size is attained.
 It is finally recommended that supervisory authorities in conventional
systems ought to approach Islamic banking with an open mind realizing
the potential gains that this already sizable and growing market could
bring to the global economy in general and to select counter parties in
particular.
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