Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 5

Capital Structure and Risk in Islamic Financial Services

Simon Archer and Rifaat Ahmed Abdel Karim

1. INTRODUCTION

In general, the role of equity capital in firms is to absorb unexpected losses, expected losses being covered by provisions that are liabilities. In addition to equity capital, other forms of financial instruments may serve to absorb losses, notably preferred shares and convertible or subordinated debt. The essential role of such capital is the protection of creditors of the firm, making it creditworthy or solvent.

The capital structure of financial services firms such as banks and insurance undertakings, and in particular the proportion of equity capital in their capital structure, is subject to regulation, with particular reference to its ability to absorb losses without these being passed on to depositors (in the case of banks) and policyholders (in the case of insurance undertakings). “Capital adequacy” of banks is a key concern of regulators and supervisors in view of the systemic risk of contagion within the banking sector; if depositors lose confidence in the solvency of one institution and withdraw their funds, this tends to have “knock-on” effects on other banks, which can result in a banking crisis such as that experienced following the collapse of Lehman Brothers in 2008. (The failure of Lehman Brothers, however, was symptomatic rather than a cause of that crisis.)

In the case of insurance undertakings, there is not the same exposure to withdrawals ...